More Good Times Ahead

The market’s been pretty good to us lately.

Since the March issue of The Kelly Letter, we gained 3% in our computer maker, 6% in our computer security company, 8% in our online media company, 20% in our Japan investment, and 26% in our student loan firm.

Plus, let’s not lose interest in our steadily performing permanent portfolios. Double The Dow gained 2% since the last issue while Maximum Midcap gained 4%. So far this year, they’re up a respective 7% and 14%. The year is only one-quarter finished, but we can already hope for another double-digit performance from Maximum Midcap. If we get it, this will be the fourth in a row. It’s a dandy little strategy.

It wasn’t all champagne and roses. We saw losses over 5% in our semiconductor maker, our pharma company, and our electronics retailer, but none worries me. In each case, lower prices mean a chance for you to open a position on the cheap if you haven’t already done so, or to add more money to an already existing position.

Let’s take a look at the economy, and then some of our individual positions.

As expected, the Fed raised the interest rate to 4.75% and hinted that it’s probably not finished yet. We should expect another 0.25% boost to 5% at the May 10 meeting. The committee said it will continue watching economic data for direction. That means we could keep going beyond 5%. Will we get a 5.25% rate at the June 29 meeting? The futures market puts the odds at around 45%.

We find ourselves again in the situation of wanting a strong economy, but not too strong. We want people to have jobs, but not too many people or that could drive wages higher. But wait, aren’t higher wages good for workers, who will use the extra money to buy things and thereby drive profits at our companies and boost stock prices? Yes, but if too many people head out the door with fat wallets to buy things, companies will notice the demand and boost prices. A widespread bout of price-raising by another name is…inflation, and that’s what the Fed wants to avoid at all costs.

Hence, last Friday’s swoon on Wall Street. The March employment report came in strong. That sent bond yields higher and sucked money out of stocks. The benchmark 10-year yield on bonds is fast approaching 5%. If people can get 5% or more on their money in safe bonds, they’ll be less inclined to take the risk of owning stocks. That’s what happens when rates rise enough.

The expectation for the March report was for the economy to have created about 190,000 jobs. Instead, it created 211,000 and unemployment dropped to 4.7%, a five-year low. On the plus side, as far as slowing the rise of interest rates goes, wage growth rose just 0.2% instead of the 0.3% that economists expected. Most watchers say that eventually the rate of wage growth will accelerate. Full employment and accelerating wages will need to be countered by higher interest rates.

The big mystery is how the Fed will interpret the data, and where it’ll stop raising rates. A friend of mine quipped that we need to find where Chairman Bernanke has lunch and be sure to reserve the adjacent table every day of the week. I replied that even that wouldn’t help because the Fed itself doesn’t have the answers yet. It’s watching the same data we’re all watching, and the data isn’t in yet. There’s one more employment report before the May 10 meeting.

Keep in mind that in addition to not knowing what the data will be nor how the Fed will react to the data, we don’t know how the market will react to the Fed’s reaction. There’s no end to the layers before us and that, my friend, is what makes a market.

To wit, this rate-raising campaign is no spring chicken but stocks have risen steadily for some time. The latest increase was the fifteenth in the Fed’s campaign, which now stretches back two years. Yet, you’d never know trouble was brewing if you ignored news and just watched stocks.

This year’s first quarter brought returns good enough for the whole year, especially if you focus on small stocks. The Russell 2000 small-cap index rose 14% in Q1. A cigar lounge full of top-ranked forecasters has been calling for small-cap outperformance to fade away as large-caps like the Dow resume dominance. The problem is that they started calling for that more than a year ago, and so far it hasn’t happened. Some day it will, though.

Personally, I’ll stick with our approach. Sometimes the bigs lead and sometimes the smalls lead. Guess who always does well, though? The mediums. That’s where our Maximum Midcap strategy fits in. It, too, is up 14% so far this year. It probably won’t be unduly affected when performance changes from small caps to large caps.

Why has the market been rising? Partly because individual investors are pouring back into it. Mutual funds received 80% more money in January and February than in the prior year. Lots of new money and rising stocks have so far been the result of the Fed’s rate-raising campaign. It’s hard to explain that. It’s like turning up the air conditioner and feeling the room get hotter.

All of which is to say that nobody, including Yours Truly, has any clear answer about what lies dead ahead. We don’t know what the data will be, what the Fed will do with it, nor how the market will react to the Fed’s decisions.

I postulated at the beginning of the year that we’d see good performance through spring and early summer, a correction somewhere around August/September, and then an autumn rally that takes us into the beginning of next year. Despite the mystery around the Fed, I’m sticking with that forecast. So far, it’s on track.

Here’s how it could play out in my scenario. In June, the Fed either declines to raise rates or does so but indicates that it’s the last time for a while. That brings a broad relief rally that lasts a few weeks. Then, the steadily declining earnings reports — which I discussed in December and that started last quarter — begin to weigh on people, and they also notice that interest rates at or above 5% are putting a drag on the economy. That’s just in time for the traditional summer slump in August and the market could give us a plump buying opportunity before the Fall technology rally kicks off in October/November.

Is this guaranteed? No. However, I think there’s a good chance of it going that way. While we can’t know for sure, what we can know is that good companies bought on the cheap will be good investments. They always have been.

With that, let’s turn our attention to some of those good investments, starting with our Japanese market holding.

One of my favorite techniques has proven itself useful again: selling gradually. We sold half of our original position in Japan’s market on Feb. 16 for a 37% gain. I was worried about the Japanese market overheating just in time for the central bank to indicate that it will raise rates, and send the high-flying Nikkei south of 15,000 again. A gain of 37% was not bad for us, but it seemed that there could be more juice in the Japanese market. So, The Kelly Letter sold just half the position.

Thank goodness for that. The central bank said that it would start raising rates and the market reacted by going up even more. The rate-rising campaign was seen as evidence of a strong economy. The Nikkei is now at 17,563 and the remaining half of Japanese market investment is up 60%. The Nikkei hasn’t been this high since July 2000.

Part of the reason that Japan’s economy has done well is that the dollar, contrary to nearly all expectations, rose last year. With U.S. debt now above $8 trillion, a falling dollar looked like a lock
. Eight trillion is a big number, translating to some $81,000 per worker and about 60% of gross domestic product. The only time the percentage has been higher in U.S. history was during and shortly after World War 2, an extraordinary burden that the nation proudly bore. Despite America’s frightening level of current debt, the dollar rose last year. That struck me as a little fishy.

Japan wants a strong dollar because it buys more yen when brought back home. That’s why the Bank of Japan buys so many dollar reserves: to prop up the value of a dollar and increase the value of the country’s exports. So, was it Japan’s doing when the dollar rose last year? Was it China’s? I don’t think so.

I think it was the IRS’s.

A little-known tax incentive encouraged U.S. corporations to repatriate foreign earnings in calendar year 2005. Some $300 billion came home to roost as a result. It’s no coincidence that the dollar’s unexpected rise against a backdrop of record national debt happened from January 2005 to December 2005. Now that the tax incentive is unavailable, there’s no torrent of cash coming home to prop up the dollar anymore. It’s back to the fundamentals for the greenback, and with the national debt on a course to $10 trillion, it will almost certainly start heading down again.

This will hurt Japan, and so will the eventually rising interest rates from the Bank of Japan. Because of these two points and because I still feel that the calls to “buy Japan” have reached fever pitch, I’m cautious about our market investment. Owning an individual company against a shaky backdrop can be fine, but owning the whole market at twice the value as we do leaves us vulnerable to a sell-off.

That’s why I’m watching carefully for the right time to book the second half of our profits.

Our portfolio is performing well, with some exceptions. Our electronics retailer is our biggest loser at the moment, but I think we’re going to have a chance to buy more shares at or below $18, and then enjoy a recovery one of these days. Our computer technology portfolio hasn’t gone anywhere yet, but its potential keeps getting better like a spring being further compressed before bursting forth.

Here in the Kanto district of Japan, the cherry blossoms are in full bloom and it’s hanami season. A hanami is a drinking party under the trees. Perhaps where you live there’s a different way to ring in springtime. Whatever it may be, I hope that you’re enjoying the season.

I have fresh reports on First Marblehead, Microsoft, RadioShack, and Yahoo. Send me a penny and I’ll send you all of them. Information on my one-penny, one-month trial is here.

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