Interest Rates Rising Relentlessly

The yields on long-term bonds — rates that are largely beyond the control of the Federal Reserve — are rising relentlessly.

They went up on Friday. They went up yesterday when Ben Bernanke was appointed as the next Chairman of the Federal Reserve. And today, they’ve literally gone through the roof!

So even before the Fed meets next Tuesday to decide what to do next with its official rates, bond investors all over the world are effectively making that decision for them by driving up interest rates in the open market.

Most people think interest rates are decided by central banks. That may be true for short-term rates like the federal funds rate. But for almost every other interest rate — rates on 10-year Treasury notes, rates on your home mortgage, or rates on long-term corporate bonds — it’s a different story entirely.

Those rates are driven by powerful forces of supply and demand that are far beyond the control of any single individual or institution, no matter how powerful.

Why? Simple: The rate of interest is the cost of money, especially borrowed money. And right now …

The demand for borrowed money is growing by the minute. The U.S. government needs more cash to finance the budget deficit, to finance the war in Iraq and to cover the cost of reconstruction from this year’s devastating hurricanes.

Consumers need more for home financing and to cover credit cards coming due. Ditto for thousands of corporations.

Meanwhile …

The supply of lendable funds is suddenly diminishing, especially when lenders have to commit beyond just a few months. Reason: They’re afraid that resurgent inflation will erode the value of their principal. They’re worried that by the time the loans come due, they’ll be paid back in cheaper dollars.

So the formula for money is as simple as the formula for any other commodity:

increasing demand + diminishing supply = surging cost

That’s why interest rates are rising relentlessly .. and why they’re likely to continue doing so …

• no matter what Mr. Greenspan and his colleagues decide next Tuesday …
• no matter what his newly-appointed successor, Ben Bernanke, does when he becomes Fed Chairman next February, and …
• no matter how strong — or weak — the economy is in the near term.

The fact that interest rates will rise is a foregone conclusion. The only question is:

How Fast Will Rates Rise?

To help answer that question, you have two alternatives. You can look at:

A. The history of past interest-rate rises.

The basic premise: If it happened before, it could happen again. Indeed, the last time inflation was as bad as it is now, rates also rose relentlessly, much as they’re beginning to do today. And ultimately, the 3-month Treasury bill rate jumped from about 6% in June of 1980 to over 16% by the end of that year.

Total rise: More than ten full percentage points in just six months.

B. The current difference between today’s interest rates and the estimated rates of inflation.

The basic premise: If rates are far below inflation, they’ve got to start catching up.

And right now, in the best case scenario, the lowest estimate of inflation is 4.7%, even assuming all the government’s numbers are accurate. But the Fed’s key interest rate — the Fed Funds rate — is still at 3.75%, almost one full percentage point BELOW the inflation rate.

Meanwhile, in the worst-case scenario — assuming that September’s bad inflation numbers persist for the next 11 months — we’re looking at the potential for consumer inflation to rise by about 14%.

Total potential rise for interest rates: Again, as much as ten full percentage points.

Will it go that far? I don’t think so. But even if rates surge by only half that much, the impact on your investments can be dramatic. Higher interest rates, whether they come swiftly or not, are likely to continue driving down the value of:

• Financial company stocks, such as banks, insurers, and brokerage firms.
• Real-estate related investments, including home builder stocks, mortgage lenders and real estate brokers.
• Utilities and other companies with big debts.
• And, indirectly, higher interest rates are also going to drag down the stocks of auto companies, retail chains, restaurant chains and other companies that rely on consumers to continue spending with borrowed money.

Among the very first — and possibly worst — victims …

Subprime Lenders
in a Tailspin

Even with the modest rate increases we’ve witnessed so far, the mortgage market is already shaky. And the “subprime” sector of the market, focused on low-quality, high-risk lending, is crumbling.

Here are the key facts:

Fact #1. The volume of mortgages is falling.

The Mortgage Bankers Association’s loan application index is down almost 17% from its June high.

So clearly, volume is slowing. And it would probably be falling even further if lenders weren’t sacrificing margins in a desperate attempt to goose up business.

And, unfortunately for mortgage lenders, that approach causes profits to collapse. Indeed, as the CEO of one subprime lender, New Century Financial, said in late September:

“Recent trends in interest rates, coupled with concerns over housing prices, energy costs and other inflationary pressures, have caused a significant deterioration in the secondary market for loans, causing our projected operating margins to fall to unanticipated levels.”

New Century went on to slash earnings guidance due to the “tougher-than-expected environment for our industry.”

Fact #2. Losses are poised to explode.

For the past few years, mortgage lenders have practically thrown money at consumers. Home prices were surging. Interest rates were low. The job market seemed to be improving. So they figured it was a no-brainer to go all-out. In the process, however, they took on more risk than ever before in history.

They gave out cheap financing on overvalued homes.

They dished out money to buyers with no down payments.

They lent money to people with a history of bankruptcy.

They even made big loans with no proof of income.

But now, the chickens are coming home to roost — and borrowers are starting to get into big-time trouble …

⇒ Bankruptcy filings are up 14% in 2005 from a year ago. Some of that stems from the rush to file before the new federal law that just took effect. But record debt loads, record debt payment burdens, high gas prices, rising interest rates, and more are the primary causes.

⇒ The American Bankers Association recently reported that the credit card delinquency rate hit 4.8% in the second quarter. That’s the highest level in recorded history, which the ABA has going back to 1973.

And falling behind on credit card payments is usually the first step for deadbeat borrowers. Next come delinquencies on secured loans — like those on cars and mortgages. So it’s no surprise that …

⇒ Subprime lenders are reporting big spikes in their late payment rates. They include AmeriCredit, an auto lender, and Countrywide Financial, one of Accredited’s larger mortgage lending competitors.

Your action: Don’t touch interest-sensitive stocks with a ten-foot pole. And if you own them, take advantage of any rallies to unload.

More Companies Taking It on the Chin
From Rising Prices and Interest Rates
by Tony Sagami

Sherwin Williams has reported lower-than-expected Q3 profits and told Wall Street to cut its rosy expectations for the rest of the year.

Sherwin Williams’ $1.07 of profit was short of the $1.10 forecast. Worse yet, Sherwin Williams chopped its Q4 forecast from 61 cents to 41 to 49 cents and reduced its 2005 forecast from $3.20 – $3.30 to $3.15 – $3.23 a share instead.

What’s the problem? Rising raw material prices. Again! Their own words:

“We are amazed by the continuing rapid escalation in raw material costs. Unfortunately, these cost increases continue to put downward pressure on our gross margins.”

“Amazed,” they say? Well, we’ve been warning you for months about the profit-squeezing effect of rising oil costs, particularly for products (like paint) that use petroleum as a prime ingredient.

So don’t think for a minute that these raw material price increases won’t work their way to the retail level. As Sherwin Williams warns, the price you and I pay for paint is going up: “Though we are maintaining tight control over expenses,” they say, “we have no other alternative than to implement certain price increases.”

The two important things to take from this Sherwin Williams report is that (a) the threat of inflation is still growing and (b) don’t forget to connect the dots to other industries that are heavy consumers of petroleum such as airlines, chemicals, truckers, roofing, and plastic.

Worrisome Drop in Consumer Confidence

Rising inflation and interest rates if finally hitting home to average Americans as well. That’s why the Conference Board’s survey of consumer confidence showed a drop from 87.5 in September to 85.0 in October.

To put that number in perspective, you need to realize that in August, this same index was sitting at 105.5!

The Jack-and-the-beanstalk crowd — as usual — was caught completely off guard, expecting a rise to 88.2 instead.

The drop in consumer confidence isn’t a statistical fluke either. The University of Michigan survey showed a similar drop, as its consumer sentiment index fell from 89.1 in August to 76.9 in September to 75.4 in October.

What really matters now is how much this consumer angst translates into slower consumer spending. I think it’s a big factor, and the Conference Board’s top economist seems to agree:

“This degree of pessimism, in conjunction with the anticipation of much higher home heating bills this winter, may take some cheer out of the upcoming holiday season.”

It increasingly looks to me like this will be the year that the Grinch will indeed steal Christmas. If so, investors that own retail stocks should use rallies to get the heck out while the getting is good.

Bad Debts Jump at AmeriCredit

AmeriCredit make loans on used cars to people with lousy credit. But it should come as no surprise that the number of deadbeats is rising.

AmeriCredit reported its Q3 results yesterday and they were well below Wall Street’s rosy expectations. By reporting third-quarter profits of 35 cents per share, AmeriCredit fell 10 cents short of Wall Street forecasts.

To be fair, about half of that 10-cent shortfall can be attributed to Hurricane Katrina, but the truth is that the number of deadbeat loans is exploding. AmeriCredit increased its loan loss reserves from $98.7 million to $165.9 million.

The future doesn’t look so bright either. AmeriCredit took down its 2006 forecasts to $1.67 to $1.85 per share, well below the $1.95 the Wall Street gang was counting on.

Is there a connection between AmeriCredit’s rising deadbeat rate and the falling consumer confidence numbers? You bet there is! And it’s another telltale warning sign for investors.

Lexmark Shares Hit 5-Year Low!

Lexmark, HP’s main printer competitor, reported a horrible Q3 that was not only below Wall Street expectations, it also included a 50% drop in profits from a year ago … plus a warning that Q4 would be ugly as well.

Lexmark now expects Q4 profits of 40 to 50 cents, far below the 64 cents the Wall Street crowd was expecting.

The problem is twofold: weak demand and brutal price competition.

• Laser and inkjet printer revenue dropped by 10% amid aggressive pricing and weak demand. Going forward, Lexmark now expects its revenue to fall by high single digits or low double digits.
• Laser and inkjet supplies – the most profitable part of the printer business only grew by 1%.
• The only thing selling was low-end printers. You can tell because overall profit margins fell from 35.2% last year to only 29.4% in Q3.

End result: A new 5-year low for Lexmark stock.

You should, by the way, be connecting this dot to Lexmark’s largest competitor, Hewlett Packard. It’s safe to assume that the same low demand, aggressive pricing, low profit margin, and shrinking profits are affecting Hewlett Packard to the same degree — if not more.

More Trouble in Chip Land

Three chip companies delivered less-than-enthusiastic news today.

1. PortalPlayer, which makes chips for the Apple iPod, got clobbered for a 27% drop after it delivered a lukewarm Q4 forecast of 34 to 43 cents per share of profits. The midrange of that projection is well below the 41 cents Wall Street was expecting.

2. Texas Instruments admitted that it expects Q4 sales to fall between $3.43 and $3.72 billion; the mid-point of that range is below Wall Street’s $3.63 billion pipe dream.

3. Altera’s Q3 profits were 7% lower than the same period last year because of rising costs and a sales shift to lower priced chips. Furthermore, Altera said that Q4 sales would be flat — plus or minus 2% — from Q3 sales.

Now, each of these chip players operates in a slightly different segment of the chip world. But it’s clear that the semiconductor business isn’t as good as Wall Street wants it to be.

Bottom line: Despite any temporary strength in the Dow or the S&P 500, the evidence we’ve presented today is telling you that:

• Bonds are falling and interest rates are rising.
• Rising rates are hurting key sectors of the financial industry.
• Consumers are taking it on the chin.
• Technology companies are getting whacked.

This is not the picture of a new bull market. Not even close!

Your Strategy

1. Keep a large proportion of your money out of the market entirely, in safe, short-term Treasury securities or equivalent money market funds.