The Federal Reserve

Mr. Bernanke: Have Some Guts, Stop Raising Rates












Fed Chairman Bernanke's handling of the press has been anything but stellar since taking office. Hopefully he does a better job at handling the economy. He started off by confiding in the very ambitious Maria Bartiromo, assuming his comments were off the record, she rushed off to the studio and announced to the world that they were best friends and she would be the self-appointed mouth piece of the Fed.

However, if the Fed chairman wants to get back in good graces with the investment community, his best chance is to do what he says: make decisions that are data dependent and forward thinking. Do not base policy changes on rear-view-mirror data.

Employment

Recent economic data suggests the economy is slowing down. The employment data for May was simply awful. The economy created 75,000 jobs in the month, down from a few hundred thousand per month earlier in the year.

In addition, wage growth is virtually non-existent, with wages increasing $0.01 per hour in the month. That's right, if you work a 40 hour week, the average Joe and Jane got an increase of $0.40 for the week. I don't believe this covers the $20 increase in his or her gas bill. Take out a little extra for FICA, local taxes, some Fed taxes and now you are really living. The chart below clearly shows that real consumer spending has rolled over. The chart actually supports a view that the Fed should start lowering rates.


















Housing Pricing Are Coming Down

The following chart paints a very clear picture: the supply and demand for housing is becoming increasingly imbalanced which is leading to a meaningful drop in prices. The chart shows the increase in the number of homes that are for sale, it clearly shows a big increase in inventory. As one would expect, this is leading to a nice decline in prices.



What Is The Fed Waiting For?

With employment growth now anemic, wage growth a joke and the house bubble now letting out a good amount of air, what is the Fed waiting for before it stops the increases?

Some suggest that the true measure of inflation and too much liquidity is the price of gold. However, even that is now coming down.

The substance of what Bernanki says after cutting through his inexperience at communicating publicly is pretty good. After the last FOMC meeting, he suggested that it might be the end of the rate increases, since Fed policy's impact can often lag. However, after gold started rallying, he panicked and started second guessing his comments.

If the new Fed chairman sticks to his initial instincts and the data, the Fed should be done for quite a while. From looking at the two charts above, along with a lot of other data, the Fed should be ready to lower rates by October. However, does Mr. Bernanke have the confidence to do this and not wait for the data to become much worse before he stops raising rates? From the recent drop in stock prices, the market is saying he does not have that confidence and will continue raising rates.

Don't Forget About Yahoo!

As the market corrects and consolidates, do not forget about adding some Yahoo! to your portfolio. The stocks is down big and has not moved despite a positive article written in Barron's a few weeks ago. It might even be a takeover candidate.

There were even reports a few weeks ago that Microsoft executives have explored the idea of buying a stake in Yahoo!. Heck! Why not buy the whole company? When you dig into the numbers, it may not be a bad idea:

Yahoo! Market Cap. = $ 49.0 Billion
Less: Yahoo! Japan Stake = $ 12.4 Billion
Less: Alibaba (Chinese Portal) = $ 1.4 Billion
Less: Cash - Debt = $ 2.0 Billion
Enterprise Value = $ 33.2 Billion

Yahoo! is expected to generate 2005 EBITDA of $2.0 billion and 2006 EBITDA of $2.6 billion. A 16.6x multiple for 2005 and 12.8x multiple for 2006---not that expensive for a high growth company.
Microsoft has failed in almost every Internet business it has attempted to enter. Yahoo! and Google have destroyed them. And Barry Diller, the great programmer, now owns ask.com, and he plans to enter the search businesses in a big way.
Microsoft still has $34 billion in cash after the huge cash distribution to shareholders last year so it could pay cash. Yahoo! also generates margins that are better than many of the new businesses (outside of its core software business) that Microsoft is investing in. Yahoo! is also a cash generating machine like Microsoft.
While Silicon Valley despises the Redmond-based giant, a Microsoft deal could lead to a mass employee exodus, but the Yahoo! franchise name has already been built. In addition, as Yahoo!'s stock price suggests, Wall Street has not been overly enthusiastic about its performance recently.
Bill, this might be your last opportunity to become an Internet company. Let's see a hostile takeover.

Revlon Corp: Follow Up

Revlon warned it was going to miss its operating margin goals on Friday which led to the stock getting hit pretty hard. Of the six years of writing my newsletter, this is the first time one of the newsletter ideas have gotten hit so badly.

Revlon had six months of excellent performance going into May. The four years of restructuring that Stahl has been part of was beginning to working and it was picking up good momentum with its Vidal Radiance and Almay products. Sometime during the Spring, its competitors reacted to Revlon's success with a slash in prices to keep market share and create a price war.

While price wars are unpleasant, they often signal a bottom in an underperforming industry. Often when a mature industry gets stale, a new management team is brought in to rebuild one of the companies (as in this case with Revlon) and the others fall behind and react to market share losses with a drop in pricing. This is often a short term response (often about six months) driven by competitors weakness which is the result of not being focused on investing in new products.

What is happening with Revlon is almost exactly what happened in the hamburger price wars during 2002 and 2003 when investors thought that the big fast food chains were going to sell hamburger for $0.99 forever. However, from looking at McDonald's price chart, it was a great time to buy. This is most likely the case today for the cosmetics business. (McDonald's stock jumped from $14 to $35 when the price war ended.)

Revlon has done a lot of good things the last four years: restructured its balance sheet, re-invented old products, created new ones, come up with an entire new store format that has shown some success. Well-placed business investment wins out over competing purely on price over time.

Also, remember that it would be cheaper for a competitor to buy Revlon than continuing this price war. A competitor could easily afford paying a big premium for the stock to get access to its distribution network, product names and shelf space. I recommend staying with the stock and shareholders will be well rewarded. I thought Revlon could be a big bagger, but if not, it should get a nice take out price.