Fed cuts 25 bps, as expected

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent. Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters. Although readings on core inflation have improved somewhat, energy and other commodity prices have increased, and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully. The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

What does this mean for our fund? I think it means that we can continue to work at deploying capital on a consistent basis. The Fed has been successful in creating some sort of “soft-landing” for the housing collapse (i.e. avoiding another Great Depression).

I believe we will see further market turbulence as the final sub-prime write-downs finally come out the tailpipe, but that the worst is over. It may take awhile for the markets to get steady on their feet, but at least they don’t appear KO’d for the count. I think we continue along, prepared to deploy capital at a consistent basis, while taking advantage of market pullbacks.

Further Reading (Bill Gross’ Investment Outlook May 2008):

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+May+2008.htm

THE OUTLAY

It’s finally time to start investing.

The Current Market Environment

Overall company valuations appear to be relatively cheap, but I still believe market levels will contract before a sustainable rise. According to Goldman Sachs, we are still 15% above historical trough recessionary P/E levels. Furthermore, variable rate mortgage resets in the US only peaked in March so I think we are in for at least one more quarter of bank earnings surprises, write-downs and increased volatility.

In terms of timing, the S&P 500 is up over 7% for the past month and I think it will have to give some of those gains back in the near term. We should begin by investing between 60-70% of capital at these levels so we can take advantage of any market regressions.

Some of the stocks I had outlined in the target portfolio in early March should be removed from our initial outlay. These include:

• 7% in HR Block (stock up 22% since March 11)
• 5% in Sigma-Aldrich (stock up 17% since March 11)
• 5% in Sanofis-Aventis (pharmaceutical company finding too complicated, although recently bought by Buffett and Burgundy )
• 3% in Healthscreen Solutions (too illiquid)

On the other hand, I’ve added some plays that I think are timely:

10% in BCE (BCE). The only risk left in the deal is financing and TD and Teachers are both expressing confidence that it will go through. We are looking at ~15% arbitrage upside at these levels. Even if the deal doesn’t go through, we are protected by a P/E of 7x and cash yield of 4%

7% in Dollar Financial (DLLR). This company owns Money Mart in Canada and has growing operations in the US and UK . It is trading at 9.7X 2008 earnings, its the low-cost industry provider, has high-margin fee-based business, competition is waning due to increased gov’t regulation, and they only have 5% of UK market but investing to grow there. Conservative estimates indicate 32% operating growth overall.

1% in Ultrashort 200% Oil & Gas ETF (DUG). We can buy this ETF to short oil without taking on leverage. I think we can make the bet based on $112/barrel being unsustainable — it is up 80% over the past year with consensus estimates pricing it somewhere between $75-$85.

5% in Nokia (NOK). Stock is down on a profit-warning by #4 player Ericsson. However, Nokia is #1 player in global handset market with a strong focus on emerging market growth — i.e. Eastern Europe, Africa, Developing Asia — and a renewed focus on the U.S. Risks to the business include Blackberry competition, but Nokia is a proven technology leader and trades at 11.4x earnings compared to 53x earnings for RIM.