February 3, 2006
Be Ready For March Madness
Or why the investment climate will look a lot different by April.
By Brady Willett

2006 is 1-month old and already there have been many surprises.  For example, the price of gold and silver have not corrected (something they did to begin each of the last two years), the price of oil has remained stubbornly high, US stocks have held up well against some negative earnings news, and Iran has done everything possible to shock most of the world. 

These surprises aside, over the next two months there is a plethora of events that are sure to spawn even more surprises. At the risk of hyperbole, no forecast is safe until the dust settles and the month of April begins.

The Iran Foul Factor

With Russia and China coming on board all of the veto wielding members of UN are now reportedly in agreement that Iran should be referred to the UN Security Council. The consensus came with Moscow and Beijing insisting that no Security Council action be taken until March. In response to ongoing negotiations at the IAEA emergency meeting ‘Iran Threatened Full-Scale Enrichment Work’. A vote is expected today:

“The resolution under consideration at the atomic energy agency's emergency meeting this week gives Iran until the IAEA's next board meeting, in early March, to meet the agency's demand for information.”
http://seattletimes.nwsource.com/html/nationworld/2002780165_iran03.html

If the threat of the UN taking action against Iran were not enough, the Iran oil bourse is expected to begin trading in March.  There are conspiratorial commentaries that claim the US dollar is doomed the second the euro-based Iran oil market comes online.  What these commentaries neglect to mention is that so long as there isn’t a run on the dollar a weakening dollar is in the best interests of America. What will ensure that there is not run out of the US dollar? The fact that no one in Euroland will be pleased with a strengthening Euro for more than 5 seconds…

Suffice to say the Iran threat is more about the price of oil and/or geopolitical uncertainty and less about the already tried and failed theme of Euro dollar strength/US dollar weakness. In fact, if the Iran bourse proves to be the largest obstacle to US dollar hegemony in 2006 it will be a good year for the dollar.

Commodities Break-Out or Bubble?

With the Iran/oil issue likely to garner more headlines in the near term and commodities seemingly having entered a mania like phase as some indicators suggest that a correction looms, it is safe to say that commodity prices have become an important indicator.  However, exactly what commodity prices are an indicator of is open for interpretation: In recent weeks it has been said that copper – which seems to hit new highs daily - is a hedge against paper assets, sugar has rallied because of its alternative fuel properties, palladium has jumped because it is a cheaper catalytic converter alternative to platinum, and commodity prices have generally firmed as the result of pension/hedge funds jumping on board.  In reaction to these events you could point to China and India and reiterate the commodities super-cycle thesis.  However, as Wall Street houses raise their gold price targets higher after every rally and crude prices expected to endlessly rally without any falloff in demand, the commodities rally seems somewhat Googlelesqe rather than being purely fundamentals driven.

On indicator contradicting the boom in commodities is the Baltic Dry Index. The BDI, which is main indicator of rates for raw materials by sea, has been falling rapidly and is near its 2005 lows even as commodity prices go on a tear. This trend cannot and will not continue for much longer.



Curve Fears Show No Sign of Laying Up

At the end of 2005 Sandler O’Neill analyst, Jeff Harte, filed his misplaced yield curve forecast into his "things I got wrong in 2005" folder (WSJ). As recently as Monday Mr. Harte said, while referring to flattening yield curves impact on the big three US banks (C, JPM, BAC), that “The bulk of the damage has been done.  The question is when does it get better?”

For anyone who follows the Treasury yield curve Mr. Harte’s comments are nonsensical.  After all, the US yield curve inverted (2 vs. 10-year) only once in late 2005 and the curve has been on an inversion path since.  In other words, to suggest that bank earnings were seriously impacted in 4Q05 by the flattening US yield curve and that ‘the bulk of the damage has been done’ is an outright lie.


The major banks have reported worse than expected results in recent weeks and have each talked about how the flattening yield curve is negatively impacting business. However, the damage has been limited to EPS misses and idle conversation about margin pressures and has not hit future forecasts (yet) .  Although only 1-month in, 1Q06 is shaping up to be significantly worse on the earnings, margins, interest income front for financial stocks. If the curve remains inverted into March watch financial stocks lead the US markets lower into earnings season (something they did yesterday), unless…

…Bernanke Steals The Ball?

Newly appointed Fed Boss, Bernanke, is set to hold his first FOMC meeting on March 28 (same day as Israeli elections). A lot of economic reports and financial market dealings will come to pass from now until then, so it is difficult to forecast if Bernanke will be pushing to raise interest rates again.  What we do know is that when the Fed stops tightening the outlook in the financial markets could, albeit perhaps temporarily, change.  If inflationary pressures/oil subside by the end of March and/or US stocks are going nowhere – which when combined with the weak US housing market would effectively kill the seemingly immortal asset backed wealth effect in America – Bernanke could indeed try to appease investors by laying off. And in doing so arrives the remote chance of a pre-spring rally.

No Slam Dunk Speculations To Be Made

Although the financial markets are going to look a lot different by April and it would be foolish not to at least be cognizant of an expected increase in volatility, the investment options available to investors nonetheless remain much the same: a cash heavy, equities light portfolio with some exposure to precious metals. Obviously by cash that is to say paper that is not of the USD variety, and by equities that is to say stocks you are comfortable owning for the long-term.  As for ‘precious metals’, although there is great risk in the near term when buying gold/silver at current prices, longer term there is little indication that gold has reached a top.

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