Our Plan Is Working

The market fell this week when economic data showed that the Fed will probably raise rates again later in the year. For the week:

Dow -1.4%
Nasdaq -1.3%
Nasdaq 100 -1.1%
S&P; 500 -1.0%
S&P; Midcap 400 -2.4%
S&P; Smallcap 600 -2.8%

On Monday, BP (BP) reported it would temporarily shut down the Prudhoe Bay oil field in Alaska while replacing corroded pipes. Because Prudhoe represents some 8% of America’s domestic oil supply, the shutdown was expected to have a big impact on oil prices.

It did have an impact, but nothing nuclear. Prices rose 3% to more than $77 per barrel. Industry sources said earlier in the year that they expect to see $80 oil before 2007, so prices in the upper-70s don’t drop the jaw.

Analysts lowered some earnings forecasts in light of higher energy prices, though, and that’s never good for stocks. Prudential cut its estimates for Intel (INTC), for instance, and sent the stock down 1%.

For the day, the Dow lost 0.2% while the Nasdaq lost 0.6%.

Tuesday was Fed day at last.

Expectations were met when the Fed left rates unchanged at 5.25%, its first pause in more than two years. For months, investors have been asking when rates would stop rising on the assumption that unchanged rates would be good news for stocks.

All else being equal, they would be. But all else never is equal and people have recently begun asking the question behind the question, which seems to be: “What might make the Fed pause?” We know all too well by now that the answer is a weakening economy that poses little or no threat of inflation.

The no threat of inflation part is hunky dory. It’s the niggling bit about a weakening economy that has left a few folks less cheerful at the beach.

The Fed itself was in no hurry to offer a parasol to the baking masses. One member, Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, dissented from the committee’s decision by suggesting another immediate 0.25% increase in the federal funds rate. He didn’t prevail, but his idea lingered.

The committee’s policy statement said “inflation pressures seem likely to moderate over time” but that “some inflation risks remain” so the “extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”

That was not comforting in light of the morning’s incoming information that unit labor costs rose 4.2% in Q2. Economists were expecting only a 3.8% rise. The latest figure is the highest we’ve had since Q4 2004 when it came in at 5.1%. Higher labor costs create upward price pressure, also known as inflation, and that means that if price tags don’t “moderate over time” then we’ll probably see additional rate increases later in the year.

The soft landing scenario could turn into the prickly cactus skid. An economy slowing while prices rise and rates need to keep going up isn’t going to be fun for anybody. That’s why the market dropped on the day that the Fed finally paused its rate increases, the Dow by 0.4% and the Nasdaq by 0.6%.

Would Wednesday bring the hoped-for reversal pattern that we’ve all come to expect lately? It looked like it in the morning, but then those darned inflation concerns and high oil prices and earnings consequences kept popping up faster than anybody could whack them down.

Not all was dark, though. I was happy to own shares of Walt Disney (DIS) when the company reported that Q3 profits rose 40%. Worries over IT spending received a spritz of cool water when Cisco (CSCO) said fiscal 2007 sales would grow at 15 or 20%, faster than anybody thought.

But in this crummy season, good news just ain’t what it used to be and the averages changed course after lunch and headed for the turf. The Dow lost 0.9% while the Nasdaq ended the day flat.

My plan to buy quality shares on weakness during this season is working out well, and we picked up Investments are shown only to KELLY LETTER subscribers. Click to try the letter for one cent. on the cheap Wednesday.

Thursday saw a reappearance of the nut cases. The largest terrorist plot since 9/11 was rooted out by British authorities with help from the U.S. British police arrested 24 people of Pakistani origin suspected of participating in the plot. They were planning to use everyday electronic devices to ignite liquid explosives to blow up as many as 10 planes in mid-flight. The U.S. and the U.K. raised their terrorist alerts to the highest levels and airlines responded with a security crackdown so thorough that no carry-on luggage was allowed.

The point not lost on the market, however, was that the plot was foiled. That coupled with falling oil prices from lower airline demand gave investors a moment to think about earnings as they are right now, and they’re pretty good. Insurance powerhouse American International Group (AIG) beat expectations. J.C. Penny (JCP) and Target (TGT) grew profits by 37% and 13% respectively. Viacom (VIA) beat, too.

Focus on such earnings sent the market a breath higher, the Dow by 0.4% and the Nasdaq by 0.7%.

Friday got back to the business of losing money. In the market, that is. Retailers are doing just fine.

Oddly, that was the problem. July retail sales came in with a 1.4% leap higher. They fell 0.4% in June and people in the know were calling for a mere 0.8% increase in July. The 75% higher tally finger-pointed an economy that’s a little too strong to let the Fed leave rates alone for long. Folks just don’t want to stop shopping, it seems. According to the July report, they’re out buying cars, gasoline, electronic devices, building materials, and clothes.

As for me, I’m just buying cheap stocks when they appear. My plan to cherry-pick fallen stocks has seen The Kelly Letter buy two these past two weeks. My hedge against a falling market is up a mere 1% so far, but that should increase as the market grinds lower before recovering in an end-of-year rally.

I’m still monitoring our buy limit orders with an eye toward changing the prices if it looks like we won’t get enough weakness to fill them. It’s still early in this short-term down trend, however, so patience is the watch word.

Our e-commerce stock illustrates why. We doubled down on Aug. 2 at $23. It quickly rose to $25, but has since come back down to about $24. It could slip below $23 again before staging the big comeback we’re banking on. A clear upward trend has not asserted itself yet.

Our two-fold strategy of buying cheap and hiding behind our hedge is going well so far. It seems strange to say, but I’m hoping for considerably more weakness before the rally. You should be hoping for that, too. It’s the condition that will enable you to profit the most.

We’re not alone when seeking to buy more shares of good companies in bad times. In this weekend’s Barron’s, I found this bit in a story about Legg Mason’s star manager Bill Miller, who has beaten the market 15 years in a row:

Miller has trailed the S&P; for long periods before catching up at year-end. Yet, during his 15-year run of beating the S&P;, Miller was never as far behind his peers as he is now. And much of his success has depended on doubling down on stocks he believed in, to lower his average cost.

That should sound familiar, and so should this. In his second-quarter letter to fund holders, Miller wrote of the internet companies in which 20% of his portfolio is invested that they boast “superior economic franchises with the ability to earn above the cost of capital as far as the eye can see.” Their stocks’ recent woes reflect “market my
opia.”

How true. A little more myopia is all we need to put a touch more capital to work before eyesight improves.

I have fresh reports on Asset Acceptance Capital (AACC), Disney (DIS), First Marblehead (FMD), and Yahoo (YHOO). To read them along with my article on how to survive the summer slump, plus gain a full month’s access to all of my notes so far this year and my current portfolio, click here.

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