A Market in Transition

The arrival of a new and untried Fed chairman is sure to produce investor unease, says Nicholas Colas of Rochdale Research

Nicholas Colas readily acknowledges that the current economic climate is tricky. In particular, he thinks the Federal Reserve is on a "knife's edge" as to whether it has raised interest rates to the proper degree. Still, the director of research at institutional brokerage Rochdale Research doesn't think the uncertainty should necessarily ding your portfolio.

One strategy Colas suggests is focusing on individual stocks, rather than on sectors, which, he thinks might help investors sidestep macroeconomic pitfalls like the threat of an inverted yield curve -- in which key short term interest rates rise above long-term rates -- inflation, or energy prices which stay high because of the "persistent drumbeat of worry" about the political situation in the Middle East (see BW Online, 11/9/05, "Upbeat, but with an Eye on Inflation"). [Note: An earlier version of this article gave an incorrect description of the inverted yield curve.]

Colas recently spoke to BusinessWeek Online reporter Alex Halperin about the current interest-rate climate, what to look for in financial stocks, why the new Fed chairman will inevitably cause some uncertainty, and whether the return of the 30 year Treasury bond after a multi-year absence is important. Edited excerpts of their conversation follow:

What do investors have to keep in mind in the yield curve climate?

There are two issues of primary importance. The first thing is, what is the yield curve indicating about the current economy? There are a bunch of academic studies that show that a persistent inversion of the yield curve is a very good indicator of a coming recession.

That has a host of issues for investors as [they decide] what portion of money [they] want in equities? It leads to questions like "What is going to slow down the economy? Where is that slowdown going to come from, and what sectors do you want to be exposed to?"

Issue No. 2 is a little more fundamental in nature -- there's a significant incremental exposure among people who own homes and have home equity lines of credit to the short end of the curve. Most HELOCs [home equity lines of credit] are pegged in some way to the prime rate, and as the Fed continues to increase rates, every month you're going to get a bill for a slightly higher payment on your HELOC.

So what does that do to consumer spending? We've already begun to see a cooling in the housing market overall, which I believe was the intention of the Fed in the first place. But is it possible that we overshoot and create that recession that an inverted curve might indicate by raising short term rates too far?

Do you think that's going to happen?

I think we're really on a knife's edge, and that's why everyone is going to be so focused on the Bernanke testimony in front of Congress. My proclivity is to say the Fed often overshoots, and we're in an environment where they could easily overshoot and, if not cause a recession, then at least cause a pretty serious slowdown.

Do you think that the transition at the Fed will make conditions worse?

Yes. The markets like consistency, they like to understand people's thought process, and they like to understand and be able to forecast what might happen to monetary policy. Having a transition by definition creates uncertainty, particularly after an 18 year run by the predecessor.

About how long does it take to learn how to read a Fed chief?

Well, about how long does it take to learn if you want to marry somebody? It's that same order of magnitude. You really have to understand their thought process and understand what they think is important and what time they wake up in the morning so I think it's going to take the market some time.... Is it three months? No. I would say it's more like six to 12.

Are there other warning factors that investors should look out for?

An area we haven't talked yet about is inflation. We saw the latest unemployment numbers come through at very low levels, which tends to create labor cost inflation. That's the other potential warning. Gold prices have pulled back in, but obviously gold has had a tremendous run and that often is an indicator of future inflation.

In a recent Rochdale report, you talk a lot about financial stocks. At this point what are you looking for in the sector?

We're looking at companies that have good exposure to commercial lending vs. consumer lending. On the consumer side, we're worried about the slowdown in housing, and that has been a major area of expansion for consumer lending for the past five years. And we want to be focused on companies that have more exposure to corporations. Corporations late in the cycle, which is where I think we are now, tend to borrow more, so you want to look for companies that have exposure in lending to business rather than individual consumers.

Those would be names like Zions Bankcorporation (ZION), City National (CYN), KeyCorp (KEY), and CIT Group (CIT) especially, which has a very good commercial lending franchise. The investment banks have been on a tremendous tear the past couple of weeks, [like] Goldman Sachs (GS) [and] Bear Stearns (BSC). I think that's a very logical ancillary call on the notion that corporations are the ones that are looking for capital right now to do M&A transactions to expand their businesses.

In other sectors, who do you like?

We like a health-care company -- First Horizon Pharmaceutical (FHRX) -- a very interesting small cap pharmaceutical company that has a very unique, very low cost structure in developing new pharmaceuticals and in selling them. They have a very low cost salesforce and a number of very interesting drugs that they've bought in late stage development and then sell.

That's the kind of name that will work in the pharmaceutical space, which is obviously fraught with concern about the cost structure of developing new drugs and selling them.

How do you see the reintroduction of the 30 year bond affecting the yield curve?I don't know that it has an immediate impact in terms of how the stock market thinks about valuation or how it thinks about long rates. I think it's a point of interest because we finally have a peg at the long, long end of the curve, vs. either having to use the very illiquid 25-year [bond] from the last auction and the 10-year, which is more liquid but obviously of nowhere near as long a duration. From the equity point of view, I think it's a non-event unless the auction goes extremely poorly.

Do you expect a high demand for it?

I do, because I think there's a sufficient amount of demand both from international buyers and domestic buyers for long dated, fixed income, risk-free paper. Greenspan used to call the long end of the curve a conundrum [because rate hikes failed to drive up long-term rates], and I was thinking what an irony that after he leaves we actually get a sort of longer-dated conundrum.

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