Friday's Brew - Feb 9

Enjoy your fresh morning coffee with our summary and analysis of the market activity of the day and a medley of important information you should find useful. While U.S. markets generally started the day higher, we anticipate a strong reversal lower before its end. Tensions are building regarding Iran and the showdown that approaches. Market participants are becoming increasingly aware of it with each passing day. At the same time, we believe the prospect of inflation, lack of Fed induced stimulus and the possibility of a tightening, are likely to play a negative role in the market's near-term future. The rug of a potential rate cut has been pulled out from under this market now.

OVERSEAS MARKETS

After falling yesterday on interest rate concerns, Europe recovered today. The DJ STOXX 50 rose 0.44%, while the FTSE 100 improved 0.52%. Yesterday, the ECB held rates steady, but signaled that a March rate hike was a significant possibility. This spooked European markets across the board, but a day later, investors seem to have recalled that economic growth remains healthy and merger & acquisition prospects plentiful.

In Asia, the NIKKEI 225 provided inspiration as it rose 1.23% today. Japanese investors may have found incentive to buy shares after recent data proved less than supportive for a Bank of Japan rate hike in the near future. Vietnam's Ho Chi Minh Stock Index showed some profit taking, declining 2.09%. Perhaps investors who recently banged up Chinese shares have recognized that the high flying Vietnamese market may also be a bit expensive these days.

ECONOMIC DATA & ANALYSIS

The RBC Cash Index showed consumer confidence at a high 103 mark in February, the best its been since September 2004. Although the measure indicates a high degree of confidence in the current state of the economy and job market, coinciding measurements also showed concern about the next six months. And while Americans are confident in the economy, they are not attributing this confidence to their president, as George W. Bush's approval rating on his effect upon the economy measured at just 42%, while his overall rating measured at 32%.

St. Louis Fed President William Poole discussed the state of the American economy today in Missouri. What he had to say was not pleasant to hear, so those of you with heavy equity investments may want to leave the room at this point. Mr. Poole said, and I quote, "the inflation rate is likely to fall into a reasonable range this year. If, however, core inflation seems to be settling at a rate above 2 percent, then such an outcome would be unacceptable to me.'' Core inflation excludes volatile food and energy prices.

Poole indicated that if GDP were to grow at a stronger than expected 3% pace in 2007, the Fed would likely have to act to reel in inflation. Poole remains concerned about housing, but failed to mention the threat we see most imposing to the American economy in 2007/2008. Core inflation is important, but ignoring the impact of rising food and energy prices that we theorize will take hold this year and next, is ignoring the strongest factor on the economy we face in the near-term. As food and energy prices increase, wage prices must increase so that Americans can continue to spend. If wage prices fail to rise with higher costs of living, the American economy faces the threat of recession. The Fed may have to cut rates in that case, even as inflation rises, but will they... In any event, we do not foresee a pretty near-term future for the American economy.

Pending war with Iran is likely to set oil to a new and higher trading range. Iran, its allies and agents, are likely to disrupt Middle Eastern oil flow in one way or another. Even if a war is won quickly, wouldn't you expect Iranian agents to play havoc on Saudi, Kuwaiti and other refinery and distribution mechanisms.? We would. As Syria, Lebanon and Venezuela become involved, and potentially others, is it not possible that revolution can take hold in Pakistan? We think so. One thing is ironically certain; it will be a time of uncertainty, and uncertainty and instability are bad for markets.

Also, as America transitions away from oil, it will need more ethanol. While its true that the importing of ethanol from Brazil should alleviate some of the pressure on food prices, we believe global demand will increase at a greater pace than the tight market can handle. Thus, prices should rise. When the Federal Reserve is faced with its greatest challenge in years and a less than straight forward strategy is required, how will it act? We are not sure it will even be empowered to rescue the economy in that scenario.

So, whether it's recession, an inflationary environment or even depression, we anticipate that our country could be in for a tough time ahead, depending on how things play out. Now, this does not mean we recommend avoiding the confrontation of Iran. It just means that we better be prepared to contain the fire that erupts to within Iranian borders, when the time comes.

COMMODITY MARKETS

With inflation still a threat to Europe and the United States, gold strengthens as a currency hedge. Gold is 0.75% higher at this hour. We believe investors in gold cannot go wrong over the next year or two. As global insecurity becomes more and more evident, we anticipate the safe-haven nature of gold will become more attractive.

Crude oil futures are relatively unchanged ahead of a scheduled Sunday announcement from Iran that traders are well aware of. Oil seems unlikely to weaken, in our view, as investors and traders recognize that global economic growth as well as the Iranian crisis create a solid foundation at current levels. If you took our advice, you bought into oil at the $50 level when we called the bottom three weeks ago.

STOCK SPECIFIC NEWS
This is a historic day. It marks the first time a hedge fund went public. Fortress Investment Group became the first today, as its investment bankers priced its shares at $18.50. The shares opened upward of 80% more than the IPO price, as the deal was well-oversubscribed and publicized. At this hour, FIG's new shares are trading at approximately $32.

There are a few good reasons why we believe a successful trend cannot burgeon out of this first example, and they are greatly related to the incentive of creating a hedge fund in the first place. I should know, having spent months developing a business plan and strategy that I have yet to market. The key incentive of creating a management company and hedge fund is the profit incentive fee, usually 20% of profits. When you sell your stake to shareholders, suddenly some or all of that incentive is transferred. If taken away significantly from the managers, and transferred to shareholders, we believe the managers are likely to retire or perform less effectively than they did when they were working for that fee. In the case of Fortress, its managers are retaining a large stake in the firm, and that is likely the reason why its shares are trading higher. Even so, we regard this as a form of cashing out, and view it as a negative factor for investors within Fortress' fund. We will publish an in-depth article on this subject over the weekend, so please check back in.

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