Friday, January 26, 2007

Mike Hull Was Right. . . So Far

In September, DCM president Mike Hull answered a question from a client regarding the medias' worries that a hard landing was inevitable and gave our case for a soft landing. Mike said the media was wrong, as usual, on the hard landing scenario because they did not understand that while the Fed had pushed short-term interest rates much higher, long-term rates were still very tame, which would allow the economy to continue to put up positive numbers. So far, he has been right on. The worries of a recession have faded with every new economic release, and the corporate earnings reports have just been terrific. Indeed, the talk in recent days has been that the Fed may have to raise rates because employment has stayed so strong, which has kept core CPI higher than many had hoped. In our investment meeting this week, we discussed what to make of these "hot" numbers. We are still firmly in the camp that's calling for a soft landing, but we believe the recent stronger-than-expected economic data are being modestly inflated by the unseasonably warm weather that the country has enjoyed this winter. The data that the government reports is seasonally adjusted. Over the years, we have witnessed countless times when economic releases were distorted by weather. Hurricane Katrina distorted economic data for six months after she made landfall. Fourth quarter 2005 GDP was nearly 40% less than had been expected and everyone began to fret that the hurricanes would cause a recession. We explained, then, that a rebound was coming. First quarter 2006 GDP completely made up for the fourth quarter shortfall. We believe the same thing will happen again. The economy is putting up strong numbers now, but the numbers are inflated by the warm weather, and we do not believe thet are sustainable. Over the next few months, we should see a rapid retracement of much of the data. And we suspect the doomsayers will start talking about a hard landing again. But we believe once the data calms down they will show that a soft landing is, indeed, underway. Recently, in our client letter we said that we thought the Fed's next action was to cut rates, but that they would be doing so later rather than sooner. That is still our position. We also said that the stronger-than-expected economic data could be a headwind to the stock market in the short run, but that the headwinds would pass as it became clear that the economy was not accelerating. That is also still our position. Recent strong economic data has thrust Ben Bernanke and the Fed back in the headlines. There will be lots of "will they or won't they" talk regarding interest rates. We are convinced that the Fed is done raising rates, and we aren't worried that they will change course. One big reason is that the mild weather has masked the weak real estate markets. While real estate weakness is not nationwide, sooner or later its effects will become apparent in the economic data. Blessings,