Buy List Updates – Fed Ditches the Evans Rule – Yellen Freaks Out the Market

Posted by Eddy Elfenbein - Crossing Wall Street

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Yellen Freaks out the Market with her “…something on the order of six months.”  

Screen Shot 2014-03-21 at 2.27.54 AMWith those words, the new Fed Chairwoman sent world markets into a tizzy. How could that be, and what, pray tell, did she mean?

Fear not, gentle reader, for I am well versed in the convoluted sub-dialect of Fed-speak, and I’ll lead you through Wall Street’s latest hissy fit. The bottom line, as I’ll explain later, is not to worry. Traders are freaking out over nothing special.

After six painful years, the economy is slowly returning to something approaching normal. Soon, workers will be able to demand higher wages, and consumer prices will rise. This is good news — it’s what we want to happen. A side effect is that we’re soon going to return more traditional monetary policies, and that will apparently take some getting used to. In this week’s CWS Market Review, I’ll explain what you need to know.

I’ll also walk you through the latest earnings report from Oracle. The bottom line number was a tad disappointing, but that was more than made up for by rather rosy guidance. I expect the enterprise software giant soon to hit $40 per share, which it last touched 14 years ago. I’ll break it down in a bit, but first, let’s look at this week’s Fed meeting and why everyone’s scratching their heads.

The Fed Ditches the Evans Rule

Before I get into this week’s Federal Reserve meeting, let’s back up a bit and explain how we got where we are. When the economy plunged into recession, the Federal Reserve responded by dramatically cutting interest rates in an attempt to cushion the blow and hopefully turn things around. Soon, the Fed got to 0% and couldn’t cut any more. Many of the top economic models said that short-term interest rates should be negative — pay people to borrow money!

The Fed decided the best way to get below 0% was to buy bonds. Lots and lots of bonds. The fancy term for this is Quantitative Easing or QE. They tried this a few times for limited periods, but it wasn’t enough. Finally, they threw up their hands and said, “we’re going to buy bonds until things get better.” Specifically, the plan was to purchase $85 billion each month in Treasuries and mortgage-backed bonds.

The market loved the plan, and stock prices soared. But investors wanted to know: How long would the bond-buying party last? The idea floated by Charles Evans of the Chicago Fed was to lay out a specific unemployment number and say, “we won’t end QE until we hit this number.” The Fed adopted the Evans Rule and said that 6.5% unemployment was their threshold. (The Evans Rule also included 2.5% for inflation, but we’re a long way from that.)

Stock prices continued to climb, and the unemployment rated started to fall. Then some investors got nervous because we were getting close to 6.5% on jobs, but the economy obviously needed more QE. The reason is that so many people had left the workforce, and as a result weren’t counted as part of that 6.5%. In other words, the economy is weaker than that unemployment number suggests. As a result, the belief was that the Fed would soon abandon the Evans Rule (I first mentioned this in January), and that’s exactly what happened this week. The Fed ditched the Evans Rule.

Yellen Confuses the Market

Now that leads us to the next step, and here’s where things get a little complicated. Last June, the Fed signaled that it was planning to pare back on its bond purchases. The market, predictably, freaked out. This was the famous Taper Tantrum. In four months, the three-year Treasury jumped from 0.3% to nearly 1%.

Investors believed, incorrectly, that the entire rally was due to QE, so once that was gone, the market was toast. Not only did they get that wrong, but they completely misjudged the timing of the Fed’s taper decision (to be fair, the miscommunication was mostly the Fed’s fault). Ultimately, it wasn’t until December that the Fed decided to taper its monthly bond-buying by $10 billion. In January, the Fed tapered by another $10 billion, and they did it again this week.

The Fed had said they wouldn’t raise interest rates until they were done with bond-buying. Sure, that makes sense. But now that they’re tapering, here’s the big question: How long will it be between the ending of QE and the first rate increase? In Wednesday’s policy statement, the Fed said “a considerable time,” so when Janet Yellen faced the media at her press conference, someone asked, “Well…what does a considerable time mean?” Her answer was “something on the order of six months.”

The next logical question is, “Six months from when?” Yellen said of QE’s end, “we would be looking at next fall.” That totally confused reporters. Did she mean fall of 2015? Nope, Yellen clarified by saying she meant this fall. Now six months from this fall means…a rate hike next spring? Hold on! That’s earlier than the market was expecting.

As a result, stocks dropped on Wednesday, and the middle part of the yield curve bulged. The three-year Treasury yield rose by 16 basis points, and the five-year jumped by 19 points. The two- and three-year Treasuries’ yields reached six-month highs. Utility stocks, which are highly sensitive to interest rates due to their rich yields, took a beating. On the forex market, the yen dropped against the dollar, and that took a 1.5% bite out of AFLAC‘s (AFL) stock during Wednesday’s trading. Gold, which had been doing well, has lost more than 4% this week.

When Will the Fed Raise Rates?

But does Yellen’s timetable make sense? With this latest taper, the Fed will be buying $55 billion in bonds starting with April. Follow me on this. The Fed meets again in April (they meet every six or seven weeks), so presumably another $10 billion taper would bring us down to $45 billion. Then we’d go to $35 billion at the June meeting. For July, we’d be down to $25 billion. Then in September, we’re down to $15 billion.

The next meeting would be on October 28-29. If the Fed wiped out the last $15 billion in one move, that would mean QE wraps up in November, which is indeed in the fall, as Yellen mentioned. But if the Fed tapers by only $10 billion in October, that leaves $5 billion on the table to tapered at the December meeting. That would mean that QE would be done by the end of the year. Counting six months from that, it means we’d see the first rate increase by the middle of 2015. That’s more in line with what the futures market had been expecting.

The market got tripped up by Yellen’s mention of “the fall” and “six months.” So here’s my take: I think this was a rookie mistake by Janet Yellen. I strongly doubt there’s anything close to a majority at the FOMC that thinks interest rates will rise next spring. The economy is getting better, but we still have a ways to go, and the CPI numbers are barely moving.

Let’s also bear in mind that we’re only talking about one measly rate increase. On Wednesday, the one-year Treasury yield skyrocketed all the way up to highest yield in five months — 0.15%! For an investment of $1 million, that works out to about $4 per day.

Make no mistake: higher interest rates are like Kryptonite to a bull market. I think the market is paranoid that a hawkish Fed is suddenly going to spring on them. It’s as if they’ve adopted an attitude of “prove to me that you’re going to let me down.” That, combined with a few misstatements from Chairwoman Yellen, explains what happened. Higher rates are truly something to worry about, but for now, they’re still a long way off.

Stocks rebounded impressively on Thursday. In fact, the S&P 500 barely budged between Tuesday’s and Thursday’s close. But we’re in a new world. Investors need to realize that the Fed will tighten at some point. It’s no longer a distant hypothetical. Currently most FOMC members think short-term rates will be at 1% by the end of next year, and 2.25% by the end of 2016. In other words, the Fed Funds rate will still be less than inflation for a good while more.

Let me add one more point. The FOMC’s policy statements have gotten ridiculously long. Dear Lord, they run on and on, with lots of garbage text. Please. Just tell us the basics. A Fed statement should be no more than 300 words. Period.

Oracle Misses Earnings, but Don’t Fret

After the closing bell on Tuesday, Oracle (ORCL) reported fiscal Q3 earnings of 68 cents per share. This was two cents below Wall Street’s consensus. It was also at the bottom of Oracle’s own guidance. The stock dropped sharply in the after-hours market. But as I said last week, what was more important than the actual earnings report would be Oracle’s guidance for the current quarter.

On the conference call, Oracle said to expect fiscal Q4 earnings to range between 92 and 99 cents per share. The Street had been expecting 96 cents per share, so that left open the possibility of an earnings beat.

On the revenue side, Oracle said it sees Q4 revenues coming in between $11.3 billion and $11.7 billion. Wall Street had expected $11.5 billion. New software sales and subscriptions would range from 0% to 10%. The best news was that hardware sales rose by 8%. That’s Oracle’s first increase since they bought Sun Microsystems four years ago. Total revenue climbed 4% to $9.31 billion, which was $50 million shy of Wall Street’s forecast.

At the start of Wednesday’s trading, shares of ORCL opened down more than $1. Gradually, traders realized that their guidance wasn’t so bad, and Oracle rallied throughout the day. Oracle finally made it into the green and got as high as a 12-cent gain on the day. The rally was later undone by Janet Yellen’s comments, but Oracle moved largely in line with the rest of the market.

Oracle’s business still needs to improve, but I think they’re making the right moves. I expect the shares soon to break $40, which the stock last hit 14 years ago. Oracle remains a good buy up to $41 per share.

Buy List Updates

Our Buy List continues to hold up well. I have a few updates to pass along. Microsoft (MSFT) closed above $40 per share for the first time since 2000 (notice how a lot of tech stocks are hitting 14-year highs). The software king is planning to release Office for the iPad, and Morgan Stanley had good things to say about their prospects. I’m raising my Buy Below on Microsoft to $43 per share.

The Federal Reserve just completed its latest bank “stress test,” and Wells Fargo (WFC) passed with flying colors. The Fed wants to make sure that if things go kablooey, the large banks won’t come running back to Uncle Sam for more bailout cash. Since Wells is so well run, there wasn’t any doubt it would do well.

The next part of the Fed’s decision comes next week when they say who’s allowed to increase their dividend. Again, I’m sure Wells will get whatever they ask for. WFC currently pays 30 cents per share each quarter. I’m expecting that to rise to 32 cents per share, give or take. Shares of WFC just broke out to another new 52-week high. I’m raising my Buy Below on Wells Fargo to $54 per share.

Shares of Qualcomm (QCOM) have been doing well lately. The stock just hit — take a wild guess — a 14-year high. There’s a chance we might get a dividend increase soon. I’m bumping up my Buy Below on QCOM to $82 per share. This is a very good stock.

That’s all for now. Next week is the final full week of the first quarter. We’re going to be getting more economic reports that aren’t tainted by the inclement weather. On Wednesday, the Department of Commerce will release its latest report on durable goods. Then on Thursday, the government will revise the Q4 GDP report. Last month, the original report was revised downward from 3.2% to 2.4%. Be sure to keep checking the blog for daily updates. I’ll have more market analysis for you in the next issue of CWS Market Review!

– Eddy

P.S. Do you know the difference between the different types of stock orders? Don’t be embarrassed. Many experienced investors don’t. Check out my handy guide to the different types of stock orders.

Named by CNN/Money as the best buy-and-hold blogger, Eddy Elfenbein is the editor of Crossing Wall Street. His free Buy List has beaten the S&P 500 for the last seven years in a row. This email was sent by Eddy Elfenbein through Crossing Wall Street.