A Fizzing Cocktail

It was a strange week, a fizzing cocktail of earnings reports, meeting minutes from the Fed, signs of inflation, and oil reaching an all-time high above $75 per barrel. There were winners and there were losers. We owned both in this most recent five-day adventure.

First, some good news.

On the back of the Dow gaining 1.9% and the Midcap 400 gaining 3.1%, our permanent portfolios had a great week. The Dow finished the week at 11,347, just 375 points below its Jan. 2000 peak before the bear market. Another 3.3% gain will take the Dow into record high territory.

Since last week’s update, Double the Dow moved from a year-to-date gain of 7% to almost 11%, and Maximum Midcap sprinted from 11.5% to more than 18%.

Why no other investment service has discovered the steady power of leveraging the Dow and the midcap index is a mystery to me. The best way to beat the Dow may not be through clever screens to find its most alluring components, but rather by owning the entire index at twice its return or, better yet, the midcap index at twice its return. Sure, there will be down times — toward the end of summer this year, if my forecast is correct — but the long-term record of out performance is clear on both of these strategies. I’m happy to keep them front and center for you.

Our individual positions posted mixed results, with a downside bias. I consider a significant weekly move to be 2% or more in either direction. By that measure, we had two winners and four losers. The old saying is that two out of three ain’t bad. By extension, I suppose one out of three is, so our individual positions had a bad week. We’ll get to individual reports below.

Before that, some economic news worth noting.

The dollar declined about 1.4% against the yen. I mentioned last week that the probability of a declining dollar could crimp the export-driven Japanese economy. That’s one reason it’s important for us to keep an eye on the exchange rate.

Another is the U.S. economy itself. From the April 17 issue of Barron’s:

Wayne Nordberg, a senior director at Ingalls & Snyder, an investment-management firm, expects the dollar to decline 10%, which will be enough to make U.S. assets unattractive versus those in the rest of the world. “Sometime this year, in September or October, you’ll see the S&P; down 20%,” he warns.

That’s consistent with my forecast of a down market in late summer or early fall. We’ll begin preparing for it in June and July. Prior to the sell-off, I expect a rally at the conclusion of Fed rate increases.

But back to that declining dollar.

The euro is gaining appeal on the international market. Its notes in circulation are up 22% in the last year. The Sveriges Riksbank, better known as the Bank of Sweden and famous for its commencing operations in 1668 as the world’s first central bank, increased the euro allocation of its foreign-exchange reserves to 50% from 37%. The dollar got cut from 37% to 20%.

Then on Friday, Russian Finance Minister Alexei Kudrin said he didn’t see the dollar’s reserve currency status as absolute. He’s especially bothered by the buck’s volatility in recent years. “Whether it is the U.S. dollar exchange rate or the U.S. trade balance, it definitely causes concerns with regard to the dollar’s status as a reserve currency,” he said.

This “down with the dollar” talk sent gold and silver to respective 25-year and 23-year highs. On Monday, Federal Reserve Bank of Chicago President Michael Moskow pointed out that “monetary policy must be vigilant” to ensure that energy and commodity prices don’t goose inflation. That added even more luster to the defensive shine of precious metals. As real assets, they are impervious to inflation because their value simply increases as prices rise. Paper currency, by contrast, loses its value as prices rise. It takes a lot more dollars to buy a suit today than it took 200 years ago, but it takes roughly the same amount of gold.

Before the bell on Tuesday, an encouraging producer price index (PPI) helped the market to rally smartly. March core PPI was up just 0.1%, providing some reassurance that inflation is at bay. Then, the March FOMC minutes contained some dovish language: “Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much, given the lags in the effects of policy.”

A tame PPI score? The end of the tightening process? Cheers of “one and done” sounded through the streets of New York. That happiness would last all of one day.

On Wednesday, the core consumer price index (CPI) clocked in at 0.3%, higher than expected and, in fact, the biggest jump in a year. It pushed the year-over-year increase toward 2.1% from 2.0%. The CPI is the heart rate on the Fed’s list of inflationary vital signs; if it’s high, inflation is alive and well. We don’t want that. We want inflation to stay in the morgue with a tag on its toe. With Wednesday’s report, inflation showed signs of life and the chances of two more interest rate hikes increased. “Two and screwed” came the retort to Tuesday’s ebullience.

Bank Credit Analyst Research, however, stuck by its view that we’re in for just one more hike:

Equity markets cheered the release of the minutes of the latest FOMC meeting, which reinforced our view that the Fed will not hike rates by more than what has already been discounted. An end to the interest rate threat will occur because consumption is slowing enough to give the Fed comfort that inflation will not become a problem. The stimulus to consumption from housing wealth gains over the past few years is beginning to fade at a time when energy costs and interest payments are an increasing drag, and lower spending growth looms.

Speaking of energy costs as an increasing drag, let’s discuss oil and gas. Four out of the week’s five days saw oil prices close in record high territory. Here’s the recap:

On Monday, oil closed at a record high above $70 per barrel.

On Tuesday, oil closed at a record high above $71 per barrel.

On Wednesday, oil closed at a record high above $72 per barrel.

On Thursday, oil fell.

On Friday, oil closed at a record high above $75 per barrel.

It’s tough to spot, but if you look carefully you may detect a trend.

National Futures Advisory Service president John Person says it’s all due to demand. “Supplies are available but are commanding higher prices due to the uncertainties that plague the market — Iran, Nigeria, and global demand is, to say the least, more of an issue now than ever before.”

He said that summer gas prices could peak at over $5 in some parts of the U.S.

Naturally, gas that high would probably curb spending in other areas. If you drive 20 miles a day and average 15 miles per gallon, you use 40 gallons of gas a month. At $3, that costs $120. At $5, it costs $200. This is a fairly conservative scenario because most people drive farther at a lower fuel economy, and yet even this scenario sees an extra $80 per month spent on gas. Multiplied across the entire population, you can see that there will be a lot less money around for discretionary spending.

As BCA Research points out, higher gas prices are coming at the same time that interest rates are peaking in this cycle. These twin problems could leave the consumer pretty strapped over the summer.

All of which should come home to roost in late summer or early fall, right on schedule.

I have fresh reports on Applied Materials, Dell, Intel, Microsoft, RadioShack, and Yahoo. To see them, along with all other recent Kelly Letter material, please try my one-cen
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