What The Fed Is Watching

This week saw the market slip less than 1% lower, except for the Dow, which rose a tad. Iran’s apparent determination to enrich uranium for use in a nuclear weapon brought echoes of pre-Iraq war-planning from Washington and sent oil prices to $70 per barrel. Gas prices along the central coast of California have already pushed past $3 per gallon. The yield on 10-year Treasuries hit 5%. That’s a downright putrid recipe for stocks.

Yet, the news from stocks themselves remained upbeat. This week kicked off first quarter earnings season. After the close on Monday, Dow component Alcoa (AA) reported a 16% sales increase and saw its shares hit a two-year high on Tuesday. It was enough to keep the Dow positive on an otherwise down day. Alcoa is an aluminum company, and credited its strong results to demand from the commercial transportation and aerospace sectors.

Then on Thursday, General Electric (GE) reported a 9% increase in profits, in line with expectations.

More pertinent to us and our technology portfolio, Intel rival Advanced Micro Devices (AMD) had a good first quarter, but issued a warning about the second quarter. More on this below.

Next week will bring a deluge of earnings reports.

On the economic front, March retail sales strengthened a little after a February drop following January’s jump. Strength in the labor market showed up in level unemployment claims. Remember that we don’t want too much demand for workers because it will drive wages higher. Higher wages will lead to rising prices and keep the Fed raising interest rates longer to stave off inflation.

So far, though, most new jobs have been of the low-wage variety and haven’t sent incomes notably higher. The bulk of last month’s employment gains came from retail stores, restaurants, hotels, hospitals, and local government, none of which is known for making workers rich. They pushed up average hourly earnings by just 0.2% in March. They were up twice that in February. Over the last year, the increase was 3.4%, below the 3.6% gain seen in consumer prices during that same time. All’s well, right?


I mentioned last week that even the Federal Reserve isn’t sure yet. In a speech delivered Thursday, Federal Reserve Governor Donald Kohn confirmed that the Fed itself is waiting for the answers, and provided a straightforward assessment of the economy. Whenever possible, it’s best to skip the news and go straight to the source, so let’s go there now.

Federal Reserve Governor Donald Kohn spoke at a luncheon with bankers and business leaders in Oklahoma City on Thursday. I took the following from his remarks:

The economy has been expanding at a pretty good clip by historical standards — probably an annual rate of about 3.5% since midyear 2005.

Our economy has been able to register this good performance despite rising energy prices. This audience knows well that since late 2003 the price of West Texas intermediate crude oil, for delivery at Cushing, has soared from about $30 per barrel to nearly $70 recently. Nonetheless, the rise in energy prices has apparently had only a limited negative effect on the national economy. Energy costs are not nearly as important today as they once were. Since the 1970s, the energy intensity of production in the United States has fallen dramatically; indeed, on an inflation-adjusted basis, it takes roughly half as many Btu of energy to produce a dollar of GDP today than it did at the time of the 1973 oil crisis. This sharply reduced share of energy costs in total business expenses has likely limited the influence of these costs on profits, on overall consumer prices and real income, and on the economy more generally. A rough estimate puts the reduction in real GDP growth from the increases in energy prices since late 2003 at between 0.5% and 1% per year. Of course, reactions to higher energy prices are hard to predict, but the measured response of activity over the past couple of years suggests that the most recent price increases will have, at most, only a small effect on economic growth during this year.

The unemployment rate has fallen almost 0.5% from early 2005 to around 4.75% last month.

Nevertheless, the underlying rate of inflation has remained moderate. Headline inflation, of course, has been boosted by the jump in energy prices. However, the run-up in the prices of energy and other commodities appears to have had only a modest effect on prices for non-energy goods and services. The inflation rate for prices of consumer goods and services excluding food and energy, as measured by the core personal consumption expenditures (PCE) price index, has been running a bit under 2%, only about 0.5% above its rate two years ago before the spurt in energy prices began.

Inflation has been restrained, in part, by the margin of slack in labor and product markets that has persisted through much of this period.

If the past is any guide, the effect of rising interest rates is likely to be felt most visibly in housing markets. The rate for a 30-year, fixed-rate mortgage is up 70 basis points [0.70%] from its level in the middle of last year, and one-year adjustable-rate mortgages have risen more than 100 basis points [1.00%] over the same period. In addition, house prices have increased considerably relative to rents, incomes, and returns on alternative assets. Already there have been signs that housing demand has begun to moderate. Sales of both new and existing homes are down substantially from their levels last summer, and information on mortgage applications and pending home sales point to further softening in the next few months. With demand slowing, house prices also seem likely to decelerate. Indeed, we are beginning to see hints of moderation in some of the data on housing prices.

The rapid run-up in prices over the past few years and hence in household wealth, perhaps combined with the increasing ease of tapping that wealth, probably has been a major reason that households have been saving so little of their current flow of income. As house-price appreciation slows, the personal saving rate likely should begin a gradual ascent.

To be candid, however, the behavior of the housing market and the response of spending are among the great uncertainties about the economic outlook. I have sketched a benign scenario of gradual adjustment that lines up very nicely with the Federal Reserve’s assessment that overall growth should slow to a sustainable pace. But our ability to predict asset prices is very limited, especially when the trajectory of those prices is shifting, as that of house prices appears to be doing right now. Moreover, we have particular difficulty in assessing how consumers will respond to changes in their perceptions of future capital gains and actual home prices. The housing market and its effects on spending will be among the areas that Tom and I and our colleagues on the FOMC [Federal Open Market Committee, the Federal Reserve’s governing board that makes decisions on interest rates] will be monitoring most closely as we try to discern the emerging pattern of economic activity and inflation.

If, as I anticipate, economic growth moderates a touch and pressures on labor and product markets do not intensify substantially further, I believe that underlying inflation should remain roughly stable. That sanguine picture is reinforced if crude oil prices do, in fact, turn out to be relatively flat over the remainder of this year. Such a flattening of oil prices would reduce headline inflation directly and would diminish the threat of higher energy prices becoming more deeply embedded in the inflation process by raising inflation expectations. And, to date, inflation expectations have been well anchored. As I have already mentioned, it would not be surprising to see some pickup in hourly compensation, but such an acceleration may not add to price pressures.

My forecast is that the economy is in transitio
n to a sustainable pace of growth, in which case policy likely will be in transition as well. At this juncture, given the apparent strength in demand and the narrowing margin of unused resources, I am focused on making sure that inflation and inflation expectations remain well anchored. A tendency for inflation to move higher would put economic stability and the long-term performance of the economy at risk. Accordingly, for me, the critical indicators in the time ahead will be the ones that signal whether growth is indeed likely to proceed at a sustainable pace and whether inflation remains on a favorable track. This is a judgment my colleagues and I will need to make meeting by meeting as the incoming information — both the data and, critically, the timely feel for developments that we get from the Reserve Banks’ contacts in the community — help us assess the paths for the economy and price pressures.

Mr. Kohn’s entire speech is available at the Federal Reserve’s website.

As for our portfolio, we had a decent week.

Our debt collection company rose 2.5% and is now up almost 10% since The Kelly Letter invested. Our semiconductor equipment maker dropped 4% below last week’s close on Tuesday, then rebounded dramatically to close the week 0.4% higher than last. We posted moderate losses in other issues, reflecting the slightly negative market tone of the week.

Investments are shown only to KELLY LETTER subscribers. Click to try the letter for one cent. was our biggest loser, dropping 3.6% on Tuesday alone, and 3.5% for the week. More below.

Among our permanent portfolios, Maximum Midcap fell 2.1%.

With that, let’s have a closer look at Yahoo.

Tuesday was a strange one for the online media giant. Its shares dropped 3.6% after two analysts reiterated ratings, one neutral and one positive.

Oppenheimer reiterated its neutral rating. However, it wrote that it would look to upgrade “on news of stabilizing search share and successful monetization improvements,” when Yahoo reports first quarter earnings.

Piper Jaffray analyst Safa Rashtchy reiterated his outperform rating. He’s especially positive about recent advertising income and improving search data. The firm thinks there’s a good chance for revenue upside and expects the stock to react positively to any top line upside.

So, where was the bad news?

Indirectly, it might have been that Google bought a new search technology. My recent writings about Yahoo have been that improved technology is not such a banner-raising event among technology companies. They’re all improving all the time and today’s breakthrough is tomorrow’s business as usual. The improving technology must be part of a bigger business plan than just using the technology.

I think we’re seeing live evidence to support that theory.

What Google bought — after winning a bidding war against our holdings Microsoft and Yahoo — was a technology that serves up instant answers to queries without having to click to a different website. This technology is called the Orion search engine, and it was developed at the University of New South Wales in Australia.

My brow furrowed upon reading that special bulletin. I asked myself, Didn’t I just write about something like that? Why, yes. Just last week, in fact. I told you about Ask.com’s improved search engine:

It provides features that neither Google nor Yahoo offer at the moment, and it returns results as quickly as they do. For instance, many searches provide results with a small binocular icon to the left of popular listings. Hover your cursor over the icon and a snapshot of the site springs forth in a bubble. Move your cursor away and the bubble disappears. You don’t have to go to the site to see what it looks like. What a time saver. It’s interesting to note that this is similar to one of the new features in Microsoft’s Vista, mentioned above.

The key phrase therein has to be “at the moment”. Yes, as of last week, neither Google nor Yahoo offered the feature. As of this week, it’s already on the way. Microsoft has it in the new Windows Vista. Does anybody doubt that a crack team of red-eyed developers are working over the weekend to bring the same feature soon to Yahoo? I don’t.

So, if Google’s press release is what tanked Yahoo’s shares, we can rest easy.

Interested in doing more research on this? Take a look at Ask.com’s binoculars and Smart Answers. Don’t miss this great Google overview. To see another example of Yahoo’s harnessing of non-employees to create profitable content, visit Yahoo Answers.

Watch for Yahoo’s first quarter results this coming Tuesday.

That’ll do it for this week.

Don’t forget that U.S. taxes are due Monday. Send your check for $81,000 to pay off your portion of the national debt.

I hope you’re enjoying the long weekend, and that you have a very happy Easter. In a world where news of the next war is always closer than news of the next peace, it’s good to pause and reflect that the vast majority of people on Earth live each day in harmony.

And on Sunday, a lot of them will be hunting for eggs. Find and peel a beautiful one for me, would you? Japan, for all its wonders, remains egg less on this most eggy of holidays back home.

I have fresh reports on Dell, Intel, and RadioShack. If you’d like to receive those immediately and then everything else I send for the next month, please sign up for my one-cent, one-month trial. All I need is your email address and name. No credit card required.

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