Higher Long Term Yields "Ain't" So Bad! 3-8-06

Good Evening.

After years of complacency regarding low long term rates, investors have suddenly started to obsess over the recent rise in the 10 year yield. Predictably, the fears and concerns over the negative effects of higher long term interest rates seem all the more real when long bonds are actually selling off. The doomsayers are quick to reiterate their long standing argument of how the economy is being driven by consumers who use their homes as ATM machines. Surely we are in for economic doom as the debt burden increases for the masses that have over extended themselves with home equity credit lines. Naturally the world is coming to an end as financial institutions will suffer in a slowing economic environment due to these higher rates. In fact, worldwide commodities need to be sold down to the dirt as there will be no need to ever worry about economic expansion when the global economy slips into a deep recession. Of course you know this is all hog wash and is only the siren song of the Bears.

As Rocky said to Clubber Lang, "You Ain't So Bad, You Ain't So Bad"! In reality a steep yield curve is the best indication of economic growth. Historically the best economic expansions have occurred during times of increasing interest rates as well as inflation. The key is not the absolute level of interest rates and inflation, rather the acceleration to the upside. As long as these components move in a gradual fashion with high economic productivity, there should be no ill effects on the economy. For example higher mortgage rates may retard the growth in the housing sector which only leads to a rotation into the equity markets which will maintain the wealth affect for consumers. Recent history suggests that stock awareness and ownership among the general public is far heavier than at any point in time. Therefore a simple asset allocation out of real estate into stocks would keep the consumer on his spending spree. It is only when the absolute levels of interest rates are so great as to become true competition with equities would we have to be concerned. Considering the expected growth rates for corporate America, equity prices will be able to give high bond yields a real run for their money for the foreseeable future.

Your friendly neighborhood Kcap Team was fairly well positioned for the recent decline in the stock market. Our large cash hoard of approximately 40% was just what the doctor ordered providing us the ammo to scoop up some of the bargains. We have specifically been busy adding to our financial stocks in the following names: JPM, HBC, XLF, and GS.

However we have taken some healthy hits in our Gold plays. Regular readers of Kcap know that our Gold positions are long term investments. We believe the supply vs. demand imbalances as well as the inventory situation are very supportive of a Bull market in the Bullion. In addition the recent sell off, while breathtaking has still not changed the Bullish long term technical conditions for the sector. Therefore we choose to maintain our exposure in these names and in fact use the weakness to continue to slowly scale more exposure into the complex.

Traders and investors need to remember to use multiple time frames for different sectors within their portfolio. Kcap uses a trading approach for many positions and an investment approach for others. We have always thought of the Gold sector as an investment with a 12 month time frame. Therefore it will take a lot more than temporary fear over rising long rates to shake us out of this group. This is not to say that we will not trade around our positions but we will always maintain core exposure.

If You Held a Taser To Our Head:
The Bank of Japan (BOJ) will be conducting its two day meeting on interest rates starting tomorrow. The fear of tightening from the BOJ has probably been largely priced into the global markets. Therefore we would not be surprised to see at least some stabilization in the U.S. Equity Markets in the next few days. When the markets bounce it will be important to assess the conviction of the dip buyers in order to determine if the upside is of the Dead-Cat variety. Even if it is the market can afford to fall further without violating the trading range it has been stuck in for the past month. Overall we will continue to add more long side exposure in Networking and Communication Stocks, Gold Mining companies, and Financials as long as the NASDAQ holds support around 2220 - 2230.

Hope you traded well.

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