Another Rate Hike

It was a mixed week as another rate hike became certain:

Dow +1.1%
Nasdaq -0.2%
S&P; 500 -0.1%

The Fed continued its strong anti-inflation message. On Monday, Cleveland Fed President Sandra Pianalto reminded us that the core CPI has increased at an annualized rate of more than 3% during the past three months, then added that if the level persisted it would exceed her comfort level. She did concede, however, that the Fed’s current stance is close to where it should be to keep inflation at bay.

Fed funds futures priced in a 90% chance of a 17th straight 0.25% rate hike at the end of this month. The Dow fell almost 1% and the Nasdaq dropped more than 2%.

Morgan Stanley changed its mind and decided that the Fed will raise rates on June 29. What’s more, the firm thinks there’s a good chance of another increase in August. Before this week, the firm thought the Fed would pause until September. While the firm believes the market has fully priced in a June rate increase, it’s worried that it has not priced in an August increase.

Canada’s esteemed BCA Research, however, said we’re close to a bottom:

The key takeaway is that the S&P; 500 is closer to a bottom than many currently perceive because the upcoming slowdown in economic growth is rapidly being discounted. Nevertheless, our Profit Model is not signaling a contraction, only a growth slowdown. Equity valuations are attractive. The forward P/E for the S&P; 500 is on a par with the bear market trough in 2002. Once the bond market relief valve kicks in as inflation fears subside, valuations are likely to expand from current levels.

The producer price index (PPI) for May came in Tuesday at 0.2% compared to expectations of 0.5%. The core rate, which doesn’t include food or energy, rose 0.3%, higher than the 0.2% expected. The report confirmed the Fed’s recent inflation concerns and further raised the odds of a June rate hike.

May’s retail sales came in with a 0.1% increase. The expectation was for no increase. We have to dig a little deeper into the report, though, to find the real story. If we strip away gas station sales, retail sales for May actually dipped 0.1%, compared to a 0.3% rise in April. Thus, echoing the consensus view, it appears that the consumer is indeed slowing down.

This is no surprise and isn’t hard to understand. Retail sales hit their high in January. Since then, as the Fed’s concerns have highlighted, the percentage of income needed to pay for food, gas, medicine, and interest payments on loans has risen to new highs. At the same time, home prices have dropped and taken with them the “wealth effect” that sent a lot of people rich on paper out shopping.

The PPI and retail sales reports sent a shudder through the market again. The Dow fell 0.8% and the Nasdaq fell 0.9%. Gold, already down 30% in the last month, fell $40 to $569.

The biggest economic news of the week, May’s consumer price index (CPI), was reported on Wednesday. It rose 0.4%, in-line with expectations. The core rate, which is the most important component, rose 0.3% for the third month in a row. The consensus had been for just 0.2%. The report put year-over-year core inflation at 2.4%, up from last month’s 2.3%, and far above the Fed’s well-advertised 1.5% preferred level and even higher than its 2% tolerable level. That makes it intolerable.

So, we’re getting another rate hike this month.

With that settled, the stock market rallied. After falling for six weeks on inflation fears and increasing odds of a June rate hike, it was relieved to finally see the hike as a certainty instead of a possibility. The Dow gained 1% and the Nasdaq rose 0.7%.

The mood continued on Thursday. Talk of a bottom having been reached dominated the corridors of Wall Street. After all, went the refrain, the S&P; 500 has a P/E of just 15.5 so perhaps this is a time to buy, not sell. The Dow rose 1.8%, the Nasdaq 2.8%, and the S&P; Midcap 400 3.2%. Broad-based hardly describes the near total participation in the rally; 146 out of 147 S&P; 500 industry groups rose for the day.

Even Fed Chairman Bernanke helped. He said that commodity prices have pushed core inflation higher, but that rising energy costs should be manageable and that the economy is resilient.

Friday was a new day, however, and the Fed returned to its recent role as wet-carpet thrower. St. Louis Fed President William Poole said that core inflation is over his comfort zone and that the Fed might need to take action. That sent the Dow fractionally lower and the Nasdaq down 0.7%.

You’ll notice that the changeover from smallcap and midcap performance to large cap performance is still underway. Double The Dow may be this year’s winner from among our permanent portfolios. So far, it’s up 3.7% while Maximum Midcap is down 1.9%. I still maintain that the midcap strategy is superior over time, as you can see for yourself here.

The Kelly Letter took advantage of cheaper prices at the beginning of the week to add to our semiconductor maker position. It was our fourth buy, this time at $17. There is no doubt in my mind that we’ll be selling this stock one day for more than $30. If it drops further to $15 in the rough summer months still ahead of us, you can be sure that we’ll be buying more. I’ll buy it all the way to the bottom and be happy each time it hits a new low. This is clearly a case of the market being ridiculous. I just hope it remains ridiculous long enough for us to build a very large position and reap enormous profits when the semiconductor cycle turns up.

There’ve been only two other times in my career that I’ve felt his certain about a depressed stock: IBM in the mid 1990s and Disney a few years back. Both are Dow stocks and thus located in one of the safest places to find dominant companies, and both were pushed far below what was reasonable. In both cases, there was no doubt that a recovery was just a matter of time. In both cases, the stocks doubled for us and we made a great deal of profit because they were down for so long that we had a chance to continue putting money to work.

It’s happening again, following precisely the same playbook, but this time with a dominant semiconductor maker. You probably already know the company I’m writing about, but if not, I strongly urge you to find out. You will not find a more surefire way to double your money safely than this. You’ll find lies and you’ll find slick marketing with hollow promises, but you won’t find this real a deal anywhere else. The market just doesn’t get any more generous than this.

With that, onto a look at some of the recent past decisions at The Kelly Letter, and their results.

We bought Ariba (ARBA) on Sept. 14 at $6 and sold it on Feb. 21 at $9.60 for a 60% gain. The next weekend, in Note 27 sent to subscribers, I wrote:

The stock continued rising throughout the week, however, and closed at $10.33 on Friday. It’s always frustrating to see that. With the company’s own outlook for a few flat quarters, I hope that the stock settles back and that we have a chance to buy in again at a lower price to participate in the company’s long-term changeover to a subscription-based business model. Even if we don’t get that chance, though, a 5-month, 60% gain is nothing to sneeze at. As my grandfather used to say, if I could make that mistake over and over again, I’d be a happy man.

I’d also be a happy man if we get that lower price I was hoping for, and we just might. The stock almost reached $11 in mid March before heading steadily down slope to less than $7.50 this week. That’s a 22% drop since we sold. I’ll keep an eye on it. We may have a chance to repeat our $6 buy again this fall.

In the January issue of The Kelly Letter, I targeted Pacific Sunwear (PSUN) a
s the best-priced of the niche clothing retailers:

Pacific Sunwear looks to me like the best-priced of the niche clothing retailers. It competes with Abercrombie & Fitch, American Eagle Outfitters, and Urban Outfitters among others for the dollars of teenage fashion buyers. PacSun’s unique take is a focus on the sporting lifestyle, particularly the “rebel” sports of snowboarding, skateboarding, and surfing. There’s a trend in America toward longer childhoods with people staying single into their 30s and continuing youthful sports well into maturity. PacSun targets that trend with three chains:

– 754 “Pacific Sunwear” stores
– 86 “Pacific Sunwear Outlet” stores
– 173 “d.e.m.o.” stores

The first two sell board-sport clothing and accessories while d.e.m.o. sells a hip-hop line. The company is also launching a new chain called “One Thousand Steps” that will sell a different style of footwear and accessories. It expects to get about 10 of the new stores off the ground by mid year with an eventual goal of more than 600 stores. The company boasts some nice numbers including a 9% profit margin, 20% earnings growth, zero debt, and a forward P/E of 12. Shares have fluctuated between about 21 and 28 over the past year, and closed Friday at $23.58.

Part of my interest in the stock was that it had reached almost $28 in November. My initial buy target was $23, which I later lowered to $22 after the stock dipped below $23 and looked shaky on the chart. Then it hit $22 in early March and I still didn’t buy because the company’s guidance came in below analyst expectations.

Then, the stock rose quickly back to $23. Some of my more vocal — or fast-typing as the case may be — subscribers wrote to ask what had gone wrong. “You’re the buy-low guy, so what happened?” read one email subject line. In the message was the question, “Did you lose your nerve?” In fact, I did lose my nerve at $22 because of the lowered guidance. As I explained to that subscriber, lowered guidance is a pretty good reason to lose one’s nerve at times.

Indeed, this was such a time. On Mar. 20, the chairman announced his resignation. On Apr. 6, the company lowered its earnings outlook. Next came one of Wall Street’s greatest tricks that one day gets all of us. The stock began to rise for no reason whatsoever. It got back to $23 again in mid April and to $25 by early May. We’d missed out on a quick 14% gain. As if to heighten our regret, BB&T; Capital Markets maintained their buy rating on the stock and raised their 12-month price target from $27 to $30.

I won’t reprint some of the emails I received that week.

I kid you not, the BB&T; report came at precisely the stock’s high point since February. A week later, PSUN was back under $23. Two weeks ago, it came out with unsettling news that May sales rose 5.6% from a year ago, but that PacSun same-store sales fell 2.2% and d.e.m.o. same-store sales dropped 5%.

This week, PSUN traded below $19. Are we glad we waited? Of course. Am I buying now? No way. I’m watching, though, just as I’ve been doing since January. My notepad filled with pencil scribbles has a new number circled on the PSUN page, and it’s $16. That would be a pretty enticing buy price.

Lastly, there’s Sina (SINA), also targeted in the January issue with these comments:

Think of Sina as Yahoo, but in Chinese. It’s China’s second-ranked internet portal, just behind Baidu. It’s also the sixth-ranked site in the world by monthly page views. That’s despite less than 10% of China’s population being online.

Sina takes a broad portal approach with many revenue streams rather than focusing on just advertising. For instance, it offers subscription services for news, dating, games, and mobile fortune-telling. (I’d sign up for the latter if it could tell me the future price of the stock.) Its portal network consists of four destination websites to users in Greater China, including mainland China, Taiwan, Hong Kong, and overseas Chinese in North America.

Now, this is a risky investment.

China is a communist country and the government can do whatever it wants to this company. So far, it’s left well enough alone, but there are no guarantees that it won’t decide down the road that this kind of broad information sharing is just not good for the people.

Beyond that, the company is young and exhibiting the same kind of lousy numbers that U.S. internet companies exhibited several years back. Its revenue and earnings growth are currently negative, and it has $100 million in debt.

So, why the interest? Because the company has a forward P/E of just 21 and has $289 million in cash. Top-ranked Chinese portal Baidu, by comparison, has a forward P/E of 142. While Sina is not squeaky clean, it looks like the most solid bet on a fast-growing sector in the fast-growing economy of the most populous country.

Shares pushed above 34 last March, but have steadily moved downward since then to Friday’s close at $22.44. When the stock moves up, it does so in dramatic fashion. The stock’s 52-week low of 20.18 came less than a month before the high of 34.25. That’s a quick 70% gain. The stock is heading downward recently, but I think we could be nearing such a dramatic turnaround point again. I will watch carefully and let you know.

Well, watching carefully was as good as it got. We never bought. The volatility continued to quicken the pace, but required split-second timing to benefit. My buy target was $20 and the stock never came close.

By early May, it had climbed above $29, then reported an earnings decline just as rival reported increased profits. That turned up the heat on Sina’s parafin foundation, and the stock melted down to less than $23 by Friday’s close. It’s a nutty piece of paper, too. It almost hit $24 just Friday morning.

Here again, I’m content to watch.

If you’d like to follow along with me at The Kelly Letter for these and other prudent decisions, along with the occasional mistake, why not give it a shot? I’m offering a one-cent, one-month trial that takes just a moment to start. It’ll give you access to all of this year’s research on the subscriber website, along with a holding-by-holding rundown of my current portfolio with each position’s initial investment thesis, my current thoughts, and links to updates in Kelly Letter notes archived at the website. The links take you straight to the specific stock’s update, not to the top of the letter. It’s a real timesaver that subscribers love, and you can try it out for a penny.

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