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Retail sales smash expectations, the stock market rejoices that Goldilocks never leaves home without her American Express card, and the bond market nervously twitches its thumbs as it watches the equity market soar and waits for the big man to speak.

There's nothing like a strong set of economic figures to get the stock market's pulse racing and bring the buy orders out of the woodwork....and there's nothing like a soaring stock market to induce the consumer to keep spending like there's no tomorrow.

The stock market's daily stomp to new records during 1999's final months appears to have convinced the consumer, armed with cash derived from capital gains in one hand and a charge card in the other hand, that there was no better time to rush out to the mall and go on a spending rampage than the present.

December retail sales rose a much stronger than expected 1.2%, with Retail Sales growth, ex-auto, rising at twice the consensus forecast.  December's strong retail sales numbers pushed retail sales growth for 1999 to its best year since 1984, up 8.9% for the year.

While the strong sales growth experienced by grocery stores (+2.0%), gas stations (+2.5%), and drug stores (+1.7%) during the month is probably in no small part due to the Waiting for Y2K Armageddon Brigade's final preparations for a meltdown that never came, the acceleration in interest rate sensitive furniture and home furnishing sales (+1.3%) and auto sales (+1.1%) cannot be attributed to Y2K stockpiling (perhaps we are wrong and there really were people saying, "Y2K is coming, I must redecorate my home and buy a shiny new car", but somehow we don't think there were).

The pick up in sales of big ticket items during the final two months of last year, coinciding with a euphoric stock market rally and coexisting with soaring long term interest rates, is something that the economic textbooks tell us is not supposed to happen--the fact that it did happen will have the Fed whistling a far less cheerful tune than the one many stock traders have been whistling since the release of the numbers.

Chances are, many Fed members started whistling the morose tune "Our Efforts Have Been For Naught" even before the release of this morning's numbers.  Like today's retail sales data, yesterday's release of the latest survey from the Mortgage Bankers Association of America showed that interest rates are rising and consumers could care less about their rise.

The latest weekly figures on mortgage activity showed an unexpected jump, with total mortgage activity during the week increasing 8.6% on a seasonally adjusted basis.  The sharp rise in mortgage activity occurred even as mortgage interest rates were rising to their highest levels in over three years.  According to the latest weekly survey on single-home mortgage rates released by Bankrate.com today, 30-year mortgage rates averaged 8.24% in the latest week.

The inability of rising rates to curb consumer spending growth is an issue that must be addressed, probably sooner rather than later, by the Fed.  The fact that the Fed's course of action to date, market hand holding and quarter-point rate increases, has been ineffective in taming the savage economic growth spurring beast known as the wealth effect, is an issue that even Mr. Gradualist himself, Alan Greenspan, will have to address at some point.

Today's numbers continue to argue for a 50-basis point hike in rates at the next Fed meeting.  Although Greenspan's heart likely calls for a 25 basis point hike, the ineffectiveness of the Fed's first three rate hikes when combined with the election-year necessity to get the dirty work done during the first half of the year could cause even our fearless Fed leader to have a change of heart.

A 50 basis point rise in interest rates by itself will not slow an economy driven by an equity owning consumer who sees 30% annual gains as a given, but the shock to the markets that a 50-basis point rise would produce just might cause the consumer to keep a tighter hold on his wallet.  While such a hike would produce a momentary bit of discomfort, the discomfort felt by all will be far greater if the Fed falls behind the curve.

Finally, a little bird outside of our window just started singing a refrain familiar to many "It's a beautiful present day in the low inflation neighborhood".  Long time readers will already have delved under the hood of today's Producer Price numbers and noticed that intermediate goods prices continued their year long creep upward, ending the year up 3.9% after having fallen 3.3% in 1998-- with global economic growth on the rebound, the upward trend in intermediate goods prices is likely to accelerate this year, leaving producers with two choices (and leaving investors with two losing propositions): pass the price increases along to the consumer or watch profit margins shrink.         





Commentary on AOL/Time Warner deal is available here 

The greatest point gain in history, day two, erased all memories of last week's short but sharp correction from the minds of investors ravenous for a taste of technology.

Yesterday was also day two of the market's newest craze: the megarally created by a favorable take on bad news.  On Friday, investors cheered on continued signs of economic strength even as a stronger than expected employment report made a February rate hike a done deal.  Yesterday investors rallied around the AOL-Time Warner megadeal even as the deal sounded the death rattle for AOL's days as an Internet stock.

The AOL-Time Warner deal created a buying frenzy for both old and new media companies, but as we explored in more depth in our commentary on the AOL merger, the deal transforms AOL from an Internet company with a projected growth rate of 49.4% over the next 5 years into a media company with a projected annual growth rate of 21%--a growth rate that no longer justifies stratospheric Internet-like valuation levels.

Just as AOL's current shareholders could wind up the losers in yesterday's deal, the investors who bid up Yahoo yesterday could also come short if the company decides to go on the acquisition trail.  A Yahoo purchase of Disney would transform Yahoo from an Internet company with earnings growing at a 55.3% annual rate into an entertainment company growing at a 15.5% annual clip--a lowered growth rate that would induce a severe case of (P/E) multiple contraction.

Multiple contraction could soon become a word on the tips of many investors tongues, not only because the new media/old media merger feeding frenzy that is expected to develop in the wake of yesterday's merger will force a rerating of many companies, but also because despite Friday's Employment report induced exuberance interest rates are headed higher--possibly much higher.

The bond market's short lived rally last week is now looking like nothing more than a temporary bout of short covering as bond yields once again shoot up, hitting 6.65% this morning, on further signs of Fed hawkishness and strong European economic growth.

Richmond Fed President Alfred Broaddus gave the bond market a push to the downside last night when he said the economy's rapid rate of growth has increased the risks of inflation developing this year.  Bonds received a second jolt with the release of the latest trade figures from Germany, which showed exports pushing Germany's trade surplus to a record DM15.6 billion in November.  The report increases the likelihood of further rate hikes by the European Central Bank, and the strong growth in exports to the U.S. puts additional pressure on the FOMC to act decisively to curb domestic U.S. consumer driven demand.

This week's slew of economic data, with PPI and Retail Sales on Thursday and CPI on Friday, could prove to be a turning point in bond market sentiment--a turning point even further to the downside. With the bond market only expecting a 25 basis point rate hike on February 2nd, any above consensus readings from this week's round of economic reports could tilt expectations towards a 50 basis point hike--a tilt in expectations that would prove to be only a minor sting for the bond market, but could send the stock market reeling.

In today's trading, rising interest rates and the possibility of a 1/2 point rate  hike in 3 weeks will not effect a stock market still dancing in the warm rays of merger mania and with its eyes focused on the post-close release of Yahoo's earnings, but later in the week it could be a different story if any upside surprises rear their heads in Thursday's and Friday's batch of data.         


America Online Inc (AOL) and Time Warner Inc (TWX) agreed to merge today in a $190 million stock and debt deal.  Under the terms of the deal, Time Warner shareholders will receive 1.5 shares of the new company, to be called AOL Time Warner, for each TWX share held.   Based on Friday's closing prices, the deal values each Time Warner share at $112, a 72% premium to their Friday close.  AOL shareholders will own 55% of the new company after the merger.

The deal creates a dominant $40 billion in annual revenues powerhouse against which all other media and Internet companies must be measured, uniting old media and new media,  offering consumer's a full range of name brand content that can be delivered via broadband, Internet, print, cable, traditional broadcast--from e-commerce to CNN, from instant messaging to the Cartoon Network and HBO, the new company will have it covered and will be able to deliver it any way the consumer wants. 

The deal instantly makes also-rans of other companies in the field who must now struggle to find merger partners if they hope to compete with the new leader.  AOL rivals Yahoo (YHOO), Lycos (LCOS) and Excite AtHome (ATHM) will be forced to go on the acquisition trail in search of a Disney (DIS) or News Corp (NWS) in order to remain contenders in the suddenly changed landscape.  The smaller players Lycos and Excite AtHome could themselves become takeovers targets as the deal ignites a flurry of frantic mergers by major players desperate to play catch up.

Although we love the new company's business, we question whether current AOL shareholders will be as enamored of the deal after the initial cheering wears off.  The deal turns AOL from a pureplay Internet stock, the stuff of which bubbles are made by overzealous fans, into a slower growing media stock.

Prior to the deal, AOL investors were willing to pay 32 times sales for AOL's $5.25 billion in annual revenues and $715 million in EBITDA.  Time Warner investors, by contrast, were able to pick up a share of their $23.5 billion in revenues, $6.4 billion in EBITDA company for the miserly price (by today's standards) of 3.6 times sales.

With the new company's revenue base set to be dominated by the former Time Warner businesses, a set of properties which were projected to grow at a 13.8% annual pace over the next five years, the question becomes whether investors who prior to the deal had been willing to plunk down 32 times sales for the 49.4% projected growth of AOL will now be willing to pay the same premium for a company whose growth rate is dramatically lower.

The answer is, probably not.  We would expect the valuation levels accorded the new company to settle into a mid-ground between those currently enjoyed by AOL and Time Warner.  For current AOL shareholders, today's cries of joy over the creation of a new powerhouse could quickly turn into cries of sorrow as they watch the inevitable process of multiple contraction take its toll.

We have nothing but praise for the new company that has been created today, but we'll take a raincheck on its stock--lower prices lie ahead. 



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Last modified: April 02, 2001

Published By Tulips and Bears LLC