The Fed's Delicate Balancing Act

The Federal Reserve kept its near-zero short-term interest rates unchanged last week, and that lack of action has our pundits wondering how long the Fed can pretend it’s not worried about inflation before that, too, becomes a factor in the complex and slow road to recovery.

After listening to Wednesday's Federal Open Markets Committee statement, market strategists and economists concluded that if Fed chairman Ben Bernanke and his colleagues had their way, we'd stop worrying about inflation. After all, the longer-term absence of inflation, kept in check so far because people just aren’t spending much money, would be ideal for getting the economy out of its current mess: 10-year Treasury yields would remain low, the modest pace of housing activity would continue, and investors would be at least mildly positive about our economic prospects.

However, such a scenario may be tenuous at best. According to our pundits, the Federal Reserve is trying to strike a delicate balance by using non-committal statements, such as "the pace of economic contraction is slowing" and "conditions in financial markets have generally improved in recent months." The goal, our pundits say, is to keep bond investors from driving up yields and derailing the low mortgage rates that are helping the recovery in housing. They also hope to stimulate enough growth in the economy that it will rely less on stimulus money.

ISI Group policy analysts, Andy LaPerriere and Tom Gallagher, explain the Fed's difficult position. The Fed, they argue, has to stay vague, offering near-term reassurance that rates aren’t in danger of going up without making the stimulus plan look open-ended.

"We don't think the Fed wanted to encourage market pricing of late '09-early '10 rate hikes; instead, it probably wanted to avoid direct longer-term guidance," they wrote. The analysts believe the Fed will rely on future testimony from Bernanke to more clearly signal that it won't hike rates for a while.

LPL Financial chief strategist Jeff Kleintop says he sees some promising signs that the markets are undergoing a healthy recovery and becoming more stable. "The fact that this process is taking place without explicit policy action demonstrates that the markets may be coming off of the Washington life support machine," he wrote.

Barry Knapp, U.S. strategist for Barclays Capital, thinks this indicates a "credit-less" recovery, meaning we’ll see smaller, less leveraged growth as investors try to steer clear of repeating the bubble and bust cycle. Such a recovery, he says, may be mild but runs less risk of being powered by cheap capital and overextended borrowing.

“The key macroeconomic question is whether the economy can recover with capital restrictions and credit contraction. There is precedent for a credit-less recovery,” he wrote on June 25. “In the case of the recession ended March 1991, bank asset growth fell 1% in 1991 and was flat for 1992; however, GDP averaged 2.7% for the four quarters following the recession and 3.2% for the subsequent four quarters.”

Ron Muhlenkamp, the founder and president of investment firm Muhlenkamp & Company, sees similar parallels to the early 1990s. He projects that, like the recession of the '90s, it could take a couple of years for consumer confidence to return.

"This time around, with the problems in our credit markets and financial institutions, it wouldn’t surprise me if consumer confidence stays modest – subdued – for a long time coming out of this recession," he wrote in his June Sign Post commentary. "But, remember, the economy may come back long before a return of consumer confidence, similar to what happened after the 1990 slowdown. Public perception lags the economist’s definition and the markets anticipate the economist’s definition. That’s just the way it works."

So how should investors play this complicated state of affairs?

According to a June 25 report by JPMorgan strategist Thomas Lee, this might be a prime time to get in early on cyclical stocks, such as consumer discretionary companies, technology, industrials and materials. He cautions, however, that rising oil prices and the recent three-month stock market rally could translate into a possible correction in September.

Brad Sorenson, the director of market and sector analysis at Charles Schwab, sees it as a chance for investors to shake off their paralysis."[In] every situation lies an opportunity: Investors looking to make some shorter-term moves could benefit from buying stocks and funds at lower prices," he wrote on Thursday. "We continue to believe that global reflationary policies, combined with the possibility of a continued weakening of the dollar will benefit the more cyclical technology, industrials and materials sectors."

5 Bargain Growth Stocks

Growth is scarce at the moment. The average of America’s 500 largest companies saw its sales shrink 8% in its last reported quarter. Yet investors seem willing to pay high prices for shares. The S&P 500 trades at 16 times forecast 2009 earnings (a projection which assumes earnings will rise 12% this year). How that compares with the long history of stocks, we can’t say, since consensus estimates and forward price/earnings ratios weren’t always available, but the index has for more than a century traded at an average of less than 15 times trailing earnings. Forward price/earnings ratios should be lower than trailing ones.

I recently searched this full-price market with mostly sliding sales for companies that are cheap and growing. Few turned up. I started with 1,500 stocks: those in the large-company S&P 500 index along with smaller companies in the MidCap 400 and SmallCap 600 indexes. After looking for 10% increases in both sales and earnings in companies’ most recent quarters — by no means torrid growth — I was left with barely 130 stocks. Just over 50 of these had forward P/Es below 15. From these, I selecting five with strong balance sheets, listed below.

Advance Auto Parts (AAP) is benefiting from the misery of car makers, who in June sold 28% fewer cars than a year ago. Poor sales of new cars means more repairs on older ones, and Advance Auto is seeing brisk customer traffic and strong demand from garages in its more than 3,000 retail shops. Sales at longstanding stores surged 8.2% in the company’s most recent quarter, with commercial sales at those stores up 17.5%. Free cash flow swelled 34%. The stock’s dividend is a pitiful 0.6%, with less than 10% of profits paid out to stockholders, but management has spent aggressively to pay down debt. If the pace holds, the company might owe nothing by year’s end. Shares sell for 14 times earnings.

Home-health-care agencies have scrawny stock valuations at the moment. Investors fear a government health-care overhaul might lead to slashed Medicare and Medicaid reimbursement for visiting nurses. Almost Family (AFAM), a small but prosperous agency, is growing its sales and profits by greater than 20% apiece and has more cash than debt, yet its shares fetch just eight times forecast 2009 earnings. According to analysis by Jefferies & Company, an investment bank, a worst-case scenario would trim the company’s profit to $1.81 per share by 2011, while a more likely path would lead to a profit of $2.51 a share. That works out to either 13 or nine times earnings — a fair deal or an excellent one.

For thoughts on the remaining companies in the table below, have a look at some other SmartMoney stories. James B. Stewart recently made a case for investing in Buckle (BKE), a Nebraska-based seller of hip (which is to say, $80) jeans. Sales are expected to grow 15% this year and the company is debt-free with $4 a share in cash. I mentionedITT Educational Services (ESI) last month in a screen for companies producing “organic” sales growth — that is, higher sales from operations, not acquisitions. Schools are finding plenty of new customers among the jobless, and government loan programs are providing the financing. Finally, The J.M. Smucker Company (SJM) is growing at a pace that’s almost indecent for a peanut butter and jam specialist. Sales are forecast to rise more than 20% this year. I’ll focus on Smuckers and some of its pantry kin later this week with a look at why stock investors might want to cash in recent gains in banks and tech in favor of consumer staples.

Screen Survivors Company Ticker Industry Share
Price Price
Change
YTD
(%) Forward
P/E Sales
Growth
Last
Quarter
(%)
Advance Auto Parts AAP Car Parts Stores $42.24 25.53 14.18 10.32
Almost Family AFAM Home Health care 23.46 -47.84 8.57 77.30
ITT Educational Services ESI Schools 95.00 0.02 13.24 22.65
Buckle BKE Clothing Stores 30.35 39.09 11.37 24.58
The J.M. Smucker Company SJM Packaged Food 48.21 11.19 12.92 81.11

Stocks See Mild Dip Early

News at a Glance
Futures Mixed: Investors eye G-8 meeting Wednesday.
Europe Up: Banks and metals lead the way.
Asia Lower: Commodity stocks fall, offset utility, tech gains.
Crude Gains: Oil prices rise on possibility of regulation.
The Lowdown

Another drop in oil prices hit Wall Street with a Tuesday drop.

The Dow Jones Industrial Average slid 40 points to 8275 by 9:50 a.m., ahead of the Group of Eight summit Wednesday in Italy and the start of earnings season at home. After the open, the Nasdaq dipped 5 points to 1783 and the S&P 500 was down 3 to 896.

Ahead of the Wednesday start of earnings season, both Intel (INTC) and Marvell Technology Group (MRVL) saw mild boosts following upgrades from Merrill Lynch, which boosted its view on the semiconductor sector as it anticipates new demand after depleting inventories.

World markets were mixed ahead of the G-8 talks. The world leaders will meet at a time when their government debt is at its highest point since World War II, a burden that may threaten the nations' influence. European shares pushed higher, led by metal and banking stocks, as investors snapped up bargains after Monday's losses. Asian markets were broadly lower, with commodity stocks declining in response to falling oil and metal prices. Gains in utility and technology stocks, such as Tokyo Electric Power and Samsung Electronics, offset some of the losses.

Oil prices again declined on fears of reduced demand, although traders reacted to news that U.S. regulators may curb speculation on oil and gas by limiting the holdings of energy futures traders. The Commodity Futures Trading Commission will hold hearings to weigh tighter restrictions on energy markets, Chairman Gary Gensler said Tuesday in a statement. Crude slipped 16 cents to $63.89 a barrel by 9:50 a.m.

The yen and the dollar rose against the euro on investor concerns that the economic recovery is on shaky ground. Government bonds fell in advance of planned debt sales by numerous countries, including the U.S.

Corporate News
Goldman Sachs (GS) stands to lose millions from increased competition if the software allegedly stolen by ex-computer programmer Sergey Aleynikov is used by outsiders, a prosecutor said. Aleynikov was arrested July 3 at Liberty International Airport in Newark, N.J. He has allegedly transferred Goldman's proprietary trading code to a computer server in Germany, according to Assistant U.S. Attorney Joseph Facciponti who spoke in federal court July 4.
General Motors will be allowed to pursue its sale of assets to a Treasury-funded buyer, despite an appeal by some of the company's creditors. The single appeal to the bankruptcy judge's approval of the sale was filed by people with accident-related claims involving GM vehicles. They want the new company to take responsibility for current claims, but they will not prevent the sale from going forward, their lawyer Steven Jakubowski told Bloomberg.
Lear (LEAR) filed for bankruptcy protection Tuesday after creditors approved a reorganization plan. The auto-parts supplier listed debt of $4.5 billion and assets of $1.3 billion as of May 30 on documents filed in U.S. Bankruptcy Court in the Southern District of New York. The company was faced with a dramatic sales drop as global auto sales tanked this year.
The Economy
Chain store sales for the week of July 4 slipped 4.2% from the previous year, according to the latest reading of the Johnson Redbook Index. STORY