Monday, November 15, 1999

The Fed & Y2K - Who Cares? And What To Do?

The Fed will meet tomorrow on the direction of interest rates. The majority of the economic indicators since the last Fed meeting has shown a strong economy with low inflation, which bodes well for the stock market. The only indicator that showed any inflation was the Producer Price Index (the "PPI") in October when it jumped 1.1%, mainly due to a one time spike in tobacco prices and oil. The November core PPI, which came in above expectations at 0.3%, almost proved problematic, but the higher than expected gain in productivity, of 4.2%, negated the spike in the PPI, at least temporarily. Basically, companies are still able to squeeze out efficiencies in production, using the savings to offset any increase in raw materials, and keeping their own selling prices stable.
So what’s the fed to do? They don’t want to over raise interest rates and abruptly end the current expansion, but they also don’t want to sit on the sidelines and possibly watch inflation run amok. In my opinion, I think they should raise interest rates one more time, taking away the last of the three interest rate cuts they gave us at the end of last year. Even though most economic indicators are showing benign inflation, productivity gains that up to now have been able to offset any type of inflationary pressure, cannot continue to increase at the breakneck pace of the last few years. Economies around the world are beginning to recover from the 1997 – 1998 crisis, and demand for products is bound to pick-up putting pressure on capacity, which in turn would put pressure on prices as companies scramble to build additional production capacity.
So how’s the market going to react? Whether the Fed raises or leaves rates alone, the market will react positively and focus on the Fed’s interest rate bias going forward. The market has already discounted a 25 basis point hike, in fact just a month ago the market was discounting a 50 basis point hike, and that’s why we got the recent rally, because the discounted expectation changed. If the Fed raises interest rates, than the market will take it as a sign of a vigilant Fed, that is out squash inflation, and that we are done with further rate increases for the time being, which will be a positive for the market. If the Fed leaves rates unchanged than the market will have to UN-discount the 25 basis point hike, creating a rally. But the latter could prove to be risky, from a market and economic standpoint. As long as economic data continues to show strong growth with low inflation, the market will continue to rally, but the minute even the slightest signs of inflation show up, the market will begin to worry about the next Fed meeting. The former will allow for a cushion as far inflation is concerned, since it will take time for the rate hike to work it’s way through the economy, the market would be willing to live with a short term spike in inflation, assuming that the last hike will work to slow the economy down in the months to follow.
So how do you play tomorrow? As far as I’m concerned, buy those quality stocks you’ve been eyeing. If I’m right, they may get away from you quickly. And if you’re still worried about the market's reaction, but don’t want to miss out on a sudden move up, then commit 25 – 50% of the funds before the meeting, and the rest after. The initial reaction might be negative to either move, but the result should prove to be positive.
So what about Y2K? I’ve been drilled on this one. Do I sell everything and wait, do I short everything, or do I do nothing? If you’re holding stocks or mutual funds now, do nothing, but if you’ve got available cash then you can play both the long and the short side of the market for Y2K. Just remember one thing, the market usually discounts prices well ahead of fact.
I believe any major move to the downside in the market because of Y2K has been discounted already. Anyone who has wanted to sell, because of Y2K, most likely has sold already, except for a few stragglers, who’ll most likely do their selling in December. Barring any major Y2K issues, the latter sales will prove to be the bottom, rather than the top to the middle. Of course, if the Soviet nuclear arsenal launches a few nukes towards the US accidentally, the December sellers would prove to be geniuses, only problem, will anyone be left to buy stock from in January?
So how do I go long? It’s quite simple. Find solid companies that have seen a slowdown in sales because of Y2K spending freezes, and buy them. Two companies that come to mind are IBM and Unisys (UIS). Neither company has experienced a slowdown in sales because their products are becoming obsolete, or because competitors are slashing prices, but because most major corporations that these two deal with aren’t spending a dime on IT products until after Y2K. So the lost sales in the fourth quarter will most likely be made up in the first quarter of 2000. The only fundamental change here is that timing of sales has shifted from one quarter to another.
Now how about the short side? I don’t like shorting stocks, because it goes against the basic theory of the stock market, buy low sell high. But if you insist, look for companies in the basic necessity product area. These companies may experience the opposite effect of technology companies. People and companies might stock pile their products, creating enormous demand and inventory build-up in the fourth quarter, which may take through the first half of 2000 to deplete, putting pressure on year 2000 earnings.
Any downside move in the market after tomorrow will most likely be caused by a necessary correction for the NASDAQ rather than anything associated with these two events. Any spook because of Y2K in the next month that sends the market down should be looked upon as a buying opportunity rather than a time to bail. Of course, looking for ways to hedge your portfolio never hurts, but maintaining a 100% cash balance is a poor hedge, especially in a market that has proven to be resilient to a prolonged correction.
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