News Releases

Federal Reserve Action
Investment Implications

Geneva, March 22, 2005: The Fed sees strength in the economy. They also see core price levels firming. The latter observation has the market concerned. Effectively, the market has been concerned about inflation and rates for about a month, ever since Alan Greenspan made the conundrum comment concerning the fact that short-term rates were heading higher while long-term rates were remaining unchanged. If inflation accelerates, intermediate and long-term interest rates will rise. Higher interest rates mean lower P/E multiples and lower average stock prices. In addition, higher interest rates mean higher interest expense for companies and lower earnings.

On inflation, we have seen the YOY change in core PPI accelerate five consecutive months to 2.8%, which matches the highest level in the last 10 years. To find the last time core inflation was above a 2.0% annual rate for a sustained period we have to go back to the 1990-to-1995 period. Over that period the 10-year Treasury yield averaged 6.8%, versus 4.5% today. Then, the average P/E was 15X. That same multiple on forward earnings would put the S&P 500 at $1055 or 10% below the current level.

Where does the Fed go from here? Since economic growth is good and we are not yet at a policy neutral point in the rate cycle, the Fed will continue to raise rates incrementally. We estimate their target range to be 3.75% - 4.25%. The next Fed Board meeting is in May and there are five more after that to finish the year. We think the target range will be achieved in the fall, absent a sharp acceleration in inflation.

How about the stock market? Since we think economic growth and earnings will be good in 2005, it all depends on inflation and interest rates. If rates rise, as the stock market is projecting, multiples will fall and the market correction will be in the 6%-10% range. If the Fed finds balance, meaning the economy grows and inflation remains under control, the market is attractively priced at 16X forward earnings and we would expect a rally going into the summer with the catalyst being 1Q earnings and good rest-of-the-year guidance given by companies during the 1Q reporting season. Brady Investment Counsel LLC thinks the latter scenario will play out and the market will finish the year 8%- 10% higher than the current level.

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