Financial

Who’s in charge at the Fed?

Last Tuesday, the markets were euphoric when the Federal Reserve signaled that it was adopting a neutral stance on future interest rate hikes.  It was Fed Chairman Alan Greenspan’s last hurrah as the most influential Federal Reserve chairman in U.S. history.  Incoming Chairman Ben Bernanke took over this week and will chair the March Federal Open Market Committee (FOMC) meeting.  Markets soared when investors thought that the Fed had finally decided it was close to a neutral bias on subsequent interest rate hikes. 
 
So much for the brief lovefest between the markets and the Federal Reserve.  On Friday, the monthly jobs report came in stronger than expected, and the unemployment rate dipped from 4.9% to 4.7%, signaling that the U.S. economy is stronger than expected.  With labor markets tightening and an increase in wages likely, an inflation spike could soon follow.  If that occurs, the Fed would then move to cool the economy by further raising interest rates.  Yesterday the markets tanked on positive economic news, fueled by fears among investors that the Fed will shed its neutral stance and continue to aggressively raise interest rates.  Investors already anticipate that the FOMC will raise rates in March, but the markets are hoping that Fed will soon end its incessant urge to raise rates by a quarter point each time it meets.
 
This is a critical time in the U.S. economy.  If the Fed overreacts, it could send the economy into recession.  If its response is too passive, it could fuel out-of-control inflation or even stagflation.  Although I’ve been critical of some of Greenspan’s policies, I appreciate that he has anticipated market dynamics that defy traditional economic models.  For example, he anticipated accelerated productivity gains fueled by technology advances in the 1990’s.  Productivity gains helped curb inflation in the mid-1990’s, and Greenspan rightfully opposed interest rate hikes that could have deflated the Internet boom.  His successor, Ben Bernanke, has a much different interest rate philosophy.  Bernanke is a well-known advocate of targeted interest rates who prefers to use formulas to determine what the optimal interest rate.  Both men’s philosophies have merit at different stages of the economic cycle, but only one is appropriate at this stage.
 
The primary question facing the Federal Reserve right now is this–given high energy prices, a strengthening economy, and flattening productivity curve, should interest rates be raised to dampen inflation?  If energy prices decrease, or productivity picks up, further interest rate increases might not be necessary.  Neither appears to be true, unfortunately.  Energy prices will stay high through at least 2006, and increased hiring and higher wages indicate that economic growth is outpacing productivity gains.  Still, is inflation inevitable in today’s economy?  Does the Fed need to continue raising rates to fight inflation that has not yet materialized?  If Bernanke has his way, the answer would likely be yes, because economic models presently favor more rate increases.  Under Greenspan, the response would be more innocuous.  Greenspan would likely favor continuing the Fed’s neutral bias and wait for further inflationary pressures to appear before adopting a more aggressive anti-inflationary stance.  Bernanke will likely stay the course, which I hope translates into a Greenspan-style approach in the near term.
 
Regardless of who is really in charge at the Federal Reserve right now, I hope that the Fed considers that the U.S. economy has been sluggish for awhile and agrees that it is better to let the economy strengthen before succumbing to inflation fears.  In the past five years, the U.S. economy has weathered a mild recession and remained somewhat sluggish, survived two major disasters (9/11 and Hurricane Katrina), suffered through a major stock market crash and the dot.com bust, and seesawed from deflationary fears to anxiety over high energy prices.  Yet through it all, inflation has remained in check.  The Fed needs to temper its inflation fears and give the U.S. economy room to move.  I hope whoever is in charge doesn’t put a brake on the economy too soon.

Year-end Investment Scorecard

I spent some time on Monday at home reviewing our investment portfolio’s 2005 performance and investment goals for 2006.  Our portfolio performed well, in spite of a down year for the Dow 30 index (down six-tenths of one percent for the year) and an inverted Treasury yield curve.  The Dow ended lower for the first time since the 2000-02 bear market.  The S&P 500 ended the year up about 3%, its smallest gain since 1987, and the NASDAQ rose 1.97%, its third consecutive year of gains.  The gains were modest.  Generally, global markets performed better than U.S. markets did.  East Asia and Eastern Europe were especially bright spots in 2005.  The domestic markets might have ended the year on a happier note had the market not reacted negatively to news of an inverted yield curve during the last week of trading in 2005.  "Inverted yield curve" is a term that suddenly rose from obscurity to a term on virtually every investor’s lips.  Essentially, the inverted yield curve indicates that the yield on the benchmark 10-year Treasury note has begun to decrease, indicating the prospect of lower future interest rates.  Lower interest rates may sound enticing to consumers.  However, with the Federal Reserve now in the midst of raising rates, lower interest rates could be a harbinger an economic downturn.  Lower rates are often driven by lower demand fueled by lower capital spending.  Thus, news of the inverted yield curve spooked investors.
 
In 2004 I started investing in companies that recently went public and continued this strategy.  I call my modest IPO portfolio "MIPOX."  My strategy has been to participate in Dutch auction IPOs through W.R. Hambrecht, and if unavailable, buy shares immediately following IPO.  This investing strategy can be risky because companies’ share prices are often volatile following initial public offering (IPO).  Fortunately, the past two years have brought many happy returns.  Here’s a summary of MIPOX’s performance in 2005:
 
Caribou Coffee (CBOU):  -17.68% return since October 2005 IPO
Cogent Technologies (COGT):  -1.42% return since purchase in September 2005
Morningstar (MORN):  +88.89% return since May 2005 IPO
 
Overall, MIPOX’s 2005 performance was 25.38%, compared with a 140% return in 2004 driven largely by gains from Google (GOOG).
 
This year, I have set price targets for my current investments and plan to sell them once they hit those targets.  I have thus far been disappointed with both CBOU and COGT, but I expect them to perform better in 2006.  Regardless, if their share prices fall to a certain level, I will likely sell them off and reinvest if their price continues to fall.  I also have researched some new investments for 2006.  The debut of the New York Stock Exchange (Proposed symbol:  NYX) as a public entity is the investment I am most keen to pursue this year.  Two other IPOs on the horizon that have caught my attention include Tim Hortons, which Wendy’s International will spin off, and Chipotle, a subsidiary of McDonald’s.  I also have my eye on investing in a Chinese technology stock.  Shanda Interactive, an online gaming company whose stock has taken a beating, is one possibility.  I may also consider Baidu.com, the Chinese search engine, if the stock continues to drop.  Lastly, I am looking at some private media or oil investments.  I hope that MIPOX will eventually form the basis of a private equity fund I’m keen to launch over the next decade.

Anticipating the future

I shared some drinks tonight with a good friend.  We had a great time talking about all sorts of topics.  One topic sticks in my mind that I’ll share with you tonight–future investment opportunities.  My friend and I talked about anticipating the future.  He mentioned that the energy industry will continue to be hot because price of oil will continue its historic highs for the foreseeable future.  He is correct.  I pointed out that a global depression would suppress the price of a barrel of oil.  Unlikely as that is, it is a possibility.  A more likely scenerio however is that the price of oil will hover between $50 and $70 per barrel for the foreseeable future.  I talked about the rise of India and that the savvy investor will look beyond China, currently the world’s hottest market, towards India.  India, according to a BusinessWeek special report, is projected to surpassed China’s GDP in the late 21st century.  China is hot now, but public Indian companies generally offer better performance than their Chinese counterparts.  As someone married to a wife from China, it may smack of heresay to say that you should keep your eye on India over China.  However, with so many eyes on China right now, it would be wiser to be contrarian and look forward to the day when India will be just as hot, if not hotter, than China.
 
If you could look into a proverbial crystal ball and anticipate future economic trends, getting an early lead on investing opportunities, what would you see?  Here are my thoughts.  Note that I did not include the Internet, nor did I include biotechnology.  While both industries still hold great promise, they represent current trends in technology rather than future trends.
  • Energy:  Energy demand will sustain high energy prices with no viable mass-produced alternative to traditional fossil for at least 20 years.  In the near-term, the best investment opportunities may be in traditional energy exploration, such as drilling companies.  In the longer term, alternative energy producers will be a good investment.
  • India:  While India has often been mentioned along with China as an upcoming economic power, India may have even greater economy potential in the next 30 years.  Indian companies offer better investment return than Chinese company, and foreign direct investment (FDI) in India has lagged FDI in China.  It won’t for long.
  • Nanotechnology:  Nanotechnology is technology developed on a molecular scale.  Within 20 years, nanotechnology will be a viable industry that will likely revolutionize materials technology.  It may very well follow the rise of the Internet as the next great frontier.  Unfortunately, it is currently a risky area with so few public companies and available. 
  • Decentralized media:  The Web will profoundly shape journalism and media.  Currently a wild west morphing in phenomena such as eBay, e-networking, and the blogosphere, a future investment opportunity lies with those companies such as Technorati and eBay that can capitalize on these phenomena, just as Google dominates search.  Look for this trend to develop in the next five years.
  • Microcredit:  Microcredit, or extending small loans to individuals in developing countries, will become big business over the next two decades as developing countries such as India and Indonesia enter periods of sustained economic expansion.  Banks and financial institutions will benefit.
  • United States of America:  Americans are at their best when they are paranoid.  As Andy Groves likes to say, "Only the paranoid survive."  Whether it’s Hurricane Katrina or the rise of China as a world power or the trade deficit, the tendency to dismiss the United States seems to be oversubscribed.  It seems to happen with the perceived rise of a rival state.  Yet since its inception, the U.S. has survived many crises and has thrived, even in a multi-polar world.  Over the long term, invest in small- and mid-cap U.S. stocks, many of which will deliver excellent returns.
  • RFID:  Within the next decade, RFID (radio frequency identification) chips will begin to replace bar coding as a means of tracking inventory.  These microchips will allow unprecedented tracking of inventory, taking inventory management to a level not yet seen.  Companies that develop RFID or capitalize on its benefits early will have advantages over companies that do not.
  • Aging:  The world is getting aging at a rapid pace.  In the U.S., Baby Boomers are turning 60 years old.  Japan, Korea, and Europe face ever graying populations.  Companies that assist this growing, aging population, including healthcare, leisure companies, and retirement service companies, will benefit substantially from the aging population boom over the next two decades.
  • Alternative investment vehicles:  Equities, bonds, real estate, and venture capital have all matured.  Savvy investors are looking for other ways to invest.  There is a good reason why alternative investment vehicles such as hedge funds, exchange-traded funds, and gold are so popular right now–investors want to diversify.  The recent successful launch of several gold funds leads me to believe that in the future other commodity funds will launch with great success.  Possible funds could include timber funds, alternative metal funds (silver/platinum), and water funds.  Imagine holding 5% timber in your investment portfolio, which you purchased through your broker.  In the not-so-distant future, you will have that option.
I would be remiss if I did not mention that I’m sorry to hear that management guru Peter Drucker recently passed away.  He was a giant in the field of management and will be missed.  As a student of management, I appreciate his teachings, although I did not always agree with them.  He left behind a legacy that should be sustained by his foundation, the Leader to Leader Institute.