It’s All About Rates

We started the week off cautiously waiting to hear new Fed Chairman Bernanke’s Wednesday testimony to Congress on monetary policy. When the testimony came, the market rallied for two days.

It’s hard to see why, though. He said that the Fed is continuing to watch economic data for signals on what to do next. If the numbers are too robust and inflation is seen to be heading higher, the Fed will continue raising interest rates. That would put a damper on stocks, of course. Most investors now expect at least two more rate increases, one on Mar. 28 and another on May 10. The discussion from here is on the odds of a third increase.

How’s the economy looking? Pretty strong, according to this week’s reports. January retail sales climbed 2.3% and January housing starts leapt 14.5%. Inflation’s telltale signs popped up, too. January’s core PPI clocked in at 0.4% on Friday, the highest gain in a year. For the past three months, it’s declined. If the Fed concludes that an upward trend is forming, it will probably keep hiking rates.

Our permanent portfolios are cooking along steadily. The Dow 1 is up 11%. Double The Dow is up 7% and Maximum Midcap is up 10%. All three had a good week.

Let’s take a look back day-by-day, and then spend some time discussing investments of particular interest to us.

Monday
The Nihon Keizai Shimbun (literally “Japan Economy Newspaper”, the Japanese equivalent of The Wall Street Journal) reported that our Japan bank, Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free., will revise its projection of consolidated net profit for the year through March 31 to about 1.1 trillion yen, an increase of more than 100 billion yen from an earlier forecast. Profit increases are always music to the ears.

The U.S. market trended lower in the afternoon, and we took some big hits in our portfolio. There was a cloud of uneasiness over Wall Street as investors waited for Mr. Bernanke’s Wednesday testimony.

Tuesday
We got a nice jump in our Japan investments as news of our bank’s profit increase registered, and the Nikkei rose.

Back in the U.S., stocks rallied around falling oil prices. Crude hit its low for the year, dropping 2.7% on Tuesday alone, and piercing the $60 mark.

The Commerce Dept. reported that retailers had their best January sales gains since May 2004, showing that consumer spending is back on track. The Dow closed above 11,000 for the first time since Jan. 11.

Microsoft said it hopes to have the new version of its Windows operating system, called Vista, available in time for the U.S. holiday season. Microsoft has long said that Vista would be available in the second half of 2006, but is now getting specific. Expect Vista sometime in November.

Wednesday
Finally, Fed day.

New Federal Reserve Chairman Ben Bernanke’s testimony before the House Financial Services Committee put a hush across Wall Street. Not a keyboard clicked as the broadcast came live into every office. Then, as the testimony progressed, it slowly dawned on everybody that the chairman said nothing surprising and that he would continue doing business the way Mr. Greenspan had done it. That sounded fine, until people recalled that business as usual prior to the testimony was…uncertainty. So, we’re all still uncertain about what’s going to happen.

I’ve got a lifelong tip for you: it’s always uncertain. You know what’s going to happen after it happens and by then it’s too late to act in advance. So we muddle along, doing the best we can with whatever limited foresight we can manage. The day you figure out the future, email me. I have a few questions for you.

The main nugget to take away from the chairman’s testimony is that the Fed is watching the same data that we’re all watching, and that if it spells I-N-F-L-A-T-I-O-N, we should expect further interest rate increases as a countermeasure.

With all the Fed-watching in progress, some hardly noticed that oil kept heading south. On Tuesday, it fell below $60. On Wednesday, it dropped another 3% to close at $57.83. The most likely explanation was a better than expected inventory report from the Department of Energy. Last week, crude supply increased more than four times as much as the market had expected.

Our brewer Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. rose 1.7% to $41.68 after Warren Buffett’s Berkshire Hathaway reported substantial holdings in the company on Tuesday as part of required filings detailing Berkshire’s $42.7 billion stock portfolio. The documents filed with the SEC show that Berkshire owns more than 5% of the company. It’s good news when a stock in your portfolio is also in the portfolio of the world’s most successful investor. We’re down some 8% since investing, so there’s still time to get this long-term winner cheaper than both Mr. Buffett and I paid.

Thursday
At 8:23 a.m. New York time, I sent Note 23 specifying two actions to take:

–> ACTION: Stop limit sell Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. $9 (not filled)
–> ACTION: Sell 1/2 Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. (filled at $64.55, a 36.8% gain)

The former rose 4.8% to $9.45, making our day. At 8:08 p.m. New York time, I sent Note 24 revising the order to sell at $9.30, which would lock in a 55% gain for us. Did we get it? Keep reading.

The outlook for Japan banks continues to look good. The six major Japanese banking groups are expected to see their combined group net profit surge 280% to about 2.83 trillion yen for the year ending March 31. That’s even higher than the record high set 17 years ago. We have increased commission revenue and fewer bad loans to thank.

Foreign investors are showing more caution toward Japanese stocks as they become pricier relative to those in the U.S. and Europe. Japan’s Ministry of Finance reported that foreign investors last week turned net sellers of Japanese shares after 19 straight weeks of net purchases, prompted by weak overseas markets. This, more than any other concern, is what lead me to take half of our Japan market profits off the table. More on Japan below.

U.S. market closed Thursday near their best levels of the day. Hewlett-Packard (HPQ) rose 7.4% to a five-year high after issuing a solid report with positive guidance. That hurt our computer maker, though.

The Dow closed at its highest level since June 2001.

My longtime buy target, Applied Materials (AMAT), not only beat first quarter earnings projections on greater than 20% order growth, but guided up second quarter projections as well. It now sees orders up 15-20%, an increase from its previous estimate of 7-10%. Applied Materials’ earnings and guidance is consistent with my bullishness on the semiconductor capital equipment industry in 2006. I’m maintaining Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free. as a good price target for buying AMAT.

Friday
Japan’s economy achieved spectacular growth in the October-December quarter, as strength in exports added to hearty private consumption and capital spending.

One of my favorite Japan analysts, Takehiro Sato at Morgan Stanley’s To
kyo office, wrote:

The Japanese economy is on a sustainable growth trajectory near a 3% real expansion pace led by domestic private demand. With the economy performing as robustly as noted above, we look for the core CPI inflation rate to expand further into positive territory, leaving timing as the only problem for the ending of quantitative easing (QE) [that means the end of low interest rates, i.e. the beginning of higher rates]. We continue to expect this to come near the April 28 [Bank of Japan] Outlook Report.

We believe that the stock market is in the process of shoring up the bottom after already reaching our projected level of 1,700 points (TOPIX; ¥16,500 for the Nikkei 225 Average) based on investor euphoria in response to the “end of deflation” theme (namely, we take a neutral view from achievement of the target level). Although the market might temporarily soften in Apr-Jun on increased volatility for interest rates, we retain our favorable bias, and think that dips during Apr-Jun should offer excellent buying opportunities, given our bullish corporate earning outlook.

I agree. My decision to sell now is a short-term, tactical one. I believe we’ll have a chance to buy in again later this year at lower prices, and repeat our satisfactory performance from last fall. Japan is doing very well, but its stock market is in the hands of a fickle foreign investment crowd that will bolt the moment it looks like the easy money has been made. That moment looks to be about now.

When we invested, Japan was not a popular place to be putting money to work. That was good. Now, everybody’s talking about it. Six months ago, three investment newsletters recommended Japan. Last month, fifteen recommended it. That’s a sure sign of a short-term top. When we get the sag that Mr. Sato noted to be likely soon, a lot of that fickle money will leave, stocks will drop, the fundamentals will remain the same, and we’ll have a chance to buy back in at cheaper prices.

On Friday in the U.S., the market traded in a narrow range modestly lower.

As noted above, the core (that is, excluding food and energy) Producer Price Index rose 0.4% in January. That’s twice what we expected, and it broke a string of low figures. You know who else saw that report? The Fed. While one tick higher is not an alarm bell, every trend begins with a step. Will this step higher firm into a trend against which the Fed will feel compelled to act?

We don’t know. What we do know is that we have something to put on the calendar for next week. On Wednesday, the January Consumer Price Index will be reported. In light of the higher PPI, the CPI will be watched closely to see if it, too, ticked higher. If so, that will add to the risk of an additional rate increase.

That was the week.

Now, let’s look at four companies of interest to us in more detail.

E-Commerce Leader ($9.85)
Very occasionally in this business, things go exactly right. The past two days have shown us that rare experience with Investments are shown only to KELLY LETTER subscribers. Click to try the letter for free..

We bought the stock on Sept. 14 for $6 as a turnaround. It’s an e-commerce survivor from the dot-com washout and is gradually realigning its business from permanent licenses, with upfront revenue, to subscription licenses, with revenue spread out over time. This change caused license revenue to decline in the quarter ended December 31, 2005.

That’s all fine. When the realignment is complete, the company should benefit from a steady flow of cash in the form of subscription payments. That makes financial planning much easier than when a company receives lump sum payments on a sporadic basis. Plus, while license revenue was down last quarter, the backlog of subscription contracts that will turn into revenue later this year, increased.

I like the turnaround story a lot, I just think the stock may be getting ahead of the fundamentals. The company said that it expects declining license revenue to be offset by subscription revenue kicking in later this year, but that the overall growth of the company will remain essentially flat for the next few quarters.

That takes us to the end of the year, before which I think we’ll see a significant market correction. The street tires of long-term forecasts quickly, particularly when panic settles in. We often get a summer/fall panic before a year-end rally. I don’t want to see our 50% gains evaporate in the heat.

Therefore, I’ve decided to lock in profits.

The stock closed Wednesday at $9.02. On Thursday, prior to the open, I set a stop-limit order to sell at $9, locking in a 50% profit. It opened at $9.08, hit a low of $9.02, then rose all day to close at $9.45. Great!

On Friday, I moved the stop-limit order up to $9.30, locking in a 55% profit. The stock opened at $9.32 and went straight up to $9.94 before settling to close at $9.85. That puts us up 64%.

Volume was heavy the last two days as the stock rose 9%. It seems that big money is acting on something that is not widely known. I decided to pick up the phone and send some emails to see what I could find.

There’s no official news, but I’ve caught rumor of German software giant SAP acquiring this company. The pairing would make sense, as the two announced last December an agreement to work together to enable SAP’s applications to run across this company’s supply network. Although it wasn’t clear, it seemed that this company might also build software to work with SAP’s NetWeaver, a platform that combines various web applications. NetWeaver is the soul of SAP, akin to what Windows means to Microsoft.

Red Herring reported on Dec. 5:

SAP’s goal is to build an “ecosystem” of customers, partners, and ISVs (independent software vendors) around the NetWeaver platform to create a suite of applications that will become a one-stop shop for customers.

The Walldorf, Germany-based company has partnered with over 30 industry heavyweights to build composite applications that will integrate partners’ offerings with SAP’s software products. These partners include IBM, Computer Associates, Intel, Cisco Systems, and Symantec.

“We believe that customers want to buy suites because they want to solve end-to-end problems,” said Shai Agassi, president of SAP’s product and technology group.

The company, which is trying to fend off competition from its largest rival Oracle and Oracle’s upcoming Fusion platform, has been criticized in the past for not being partner-friendly and collaborative, a process that has now become important if SAP wants to create a NetWeaver ecosystem of partners.

With our company’s growing list of subscribers bulking up its supply network, it’s easy to see why SAP would be interested in not just working with the company, but owning it.

This puts us in an interesting spot. You may recall that we gained 60% on Maxtor, but sold in December just before Seagate announced that it was acquiring it. That took Maxtor up significantly higher and we missed out on extra profits. Are we facing the same situation again?

Perhaps, but there’s no telling. If the rumor fades away and there is no buying interest from SAP, the stock could head south again and the 9% gift over the last two days could disappear. Does anybody have a friend in SAP’s finance department whom I could call? Just kidding.

The prudent move is to act on what we know, so let’s move the order up to $9.60 to lock in a 60% gain. As always, we’ll hope the stock just keeps going higher from here.

To read the three additional reports on Dell (DELL), PXRE Group (PXT), and RadioShack (RSH), please sign up for a free trial to The Kelly Letter.

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