1. The Fed, interest rates and the recovery How is the Federal Reserve organized? Set up by Congress to regulate monetary policy Control the money supply, interest rates and inflation 12 Federal reserve districts  New York district is first among equals Fed’s Open Market Committee meets 8 times per year

2. How the Fed controls interest rates Banks hold funds on reserve at the Fed They maintain between 3% and 10% of total savings and checking accounts At the end of each day, banks borrow from each other or from the Fed to cover reserves They do this is a private financial market They borrow from each other at the Federal Funds rate They borrow from the Fed at the Federal Discount rate (however this is discouraged and rarely happens)

3. The Federal Funds Rate The rate at which banks borrow from each other to cover reserves Controlled by the Fed’s Open market Committee Fed does not directly set this rate Instead, it sets a target rate to be achieved through market forces If they want the rate to fall: Fed buys securities from banks and increases their reserves (increases the money supply) If they want the rate to rise: Fed sells securities to banks and takes the money from excess reserves (decreases the money supply)

4. The Federal Reserve Discount Rate Rate is directly controlled by the Fed Changing this rate surrounds “announcement type” events Banks can, but rarely do, borrow at this rate from the Fed Fed uses this rate to signal changes in monetary policy Raising the rate indicates a more restrictive policy Lowering the rate indicates an expansive policy of putting more money into the system Fed acts to keep the targeted Federal Funds rate and the Discount rate “in synch”

5. How does the Fed work? The key interest rates: March 2002October 2001October 2000 Federal Discount Rate1.25%2.00%6.00% Federal Funds Rate1.74%3.63%6.56% Prime Rate4.75%6.50%9.50% 90 day T-Bill rate1.76%3.29%6.02%

6. How does this influence the economy? When the Fed lowers rates, short –term interest rates typically move lower as well For the consumer: Short term debt Adjustable rate mortgages Automobile loan rates Home equity lines of credit For a corporation Short-term variable rate debt Leasing rates Possibly, but not necessarily long-term rates as well

7. Why not necessarily long-term rates? REMEMBER the Yield Curve! Short term rates are influenced by the Fed Long term rates are set by investors and the bond market Expectations theory – long-term rates reflect anticipated movements in short-term rates over time If the Yield Curve has an upward slope, indicates anticipated strength in the economy Higher profits and business activity make it easier to cover debt payments

8. What about the current economy? The Yield Curve has a significant upward slope beginning about 6 month out Anticipation of improved economic environment The spread between corporate bonds and government bonds is decreasing This is another indication of an improving economy Spreads are driven by a lender’s expectation of a borrowers credit quality  Ability to re-pay debt  Driven by cash flow and earnings  As of January, this spread was 4.7%; Still higher than in the past 5 years, but down from highs of 6% as recent as 4 th qtr, 2001

9. Why is the recovery expected to be weak? (SOURCES: Wells Capital Management Newsletter, Fortune Magazine, CBS Market-watch) Remember, stock values are driven by cash flow Earnings are a proxy for cash flow The investment community pays significant attention to P/E ratios: A stock’s price per share divided by earnings per share In order for prices to rise, earning must grow if P/E multiples remain stable Or Investors must accept higher multiples

10. What drives a recovery? Corporate earnings, and the resultant increase in cash flows, must occur Corporate income can increase if: Sales increase Costs decrease

11. What could drive an increase in sales? Pent-up Business demand for capital items such as plant and equipment Pent-up business demand for technology items Long-term investment opportunities Pent up consumer demand for durable goods: Housing Automobiles Major appliances

12. What could drive an increase in sales? Factory utilization is less than 75%, 60% at high-tech companies – unused capacity will be utilized before new capacity added Many feel technology dollars were spent in preparation for Y2K. Pace of technological innovations has slowed. Markets are flush with almost new equipment from dot.com burnout. Secondary market companies are flourishing Median S&P 500 technology companies have 25% of assets in cash – dearth of new investment opportunities Corporate balance sheets still heavily debt laden Concern over coming accounting changes – expense options?

13. What could drive an increase in sales? US consumption never took a big downturn Low mortgage rates and 0% financing kept housing and auto sales strong Discount stores have been strongest, i.e., Wal-Mart and Target Demand driven by lower costs does not help corporate financials Consumer debt remains at record high levels Job market uncertain because of continued increases in productivity Will poor 401(k) performance finally hit home?

14. Other issues affecting the recovery Big ticket real spending Normally think of nominal numbers being “higher” than real because of inflation Big ticket spending is now a greater % of real GDP than nominal GDP, a trend that started in the 90’s but has grown progressively pronounced This indicates a deflationary environment for big ticket spending Growth being driven by greater unit sales, but lower prices

15. Other issues affecting the recovery Labor market Although GDP indicates a mild recession, overall job loss (on a gross basis) was the largest ever. Feeling of some is that the jobless rate was helped along by little or no growth in the labor force As the economy gains steam, the fear is that a swelling labor force will offset improving economic conditions keeping unemployment close to current levels

16. Other issues affecting the recovery Interest Rates Will the Fed have to raise interest rates? Although Long-term yields have fallen slightly of late, they are still at the same levels they were before the Fed began dropping short-term interest rates

17. Other issues affecting the recovery What drives profits - cost reductions or increased sales? Historically, corporate profits were driven by increases in sales (positive correlation between GDP and corporate profits) In the 90’s this correlation turned negative – meaning corporate profits were being driven by cost reductions Around 2000, profits and sales were again positively correlated If profits are again tied to sales, could limit growth based on earlier issues regarding pent-up demand!

18. Other issues affecting the recovery The Bond Market The volatility of corporate bond yields based on standard deviation is at an all-time high Although the spread between Moody’s investment grade bonds and 10-Treasury bonds have decreased recently, they remain extremely high Is this spread the result of a risk premium in the yield curve, suggesting long-term economic uncertainty? Or is it future interest rate expectations? High quality corporate bonds are becoming an increasingly smaller part of the total value of US Corporate bonds – 55% opposed to 70% at the start of the 90’s and 85% in the early 80’s – make Treasury bonds more attractive? Historically, the correlation between stock and bond price movements has been negative. When it has turned positive, this has signaled the end of a bull market. Correlations are currently positive!

19. Other issues affecting the recovery Stock market drives – Earnings or Increased valuation through higher P/E multiples? From 1982 through 1992, P/E multiples went from 7.7 to 20.8 From 1992 through 2000, the market was driven by earnings growth with relatively stable P/E’s (except in the technology sector) Because P/E’s are at or near record highs, some feel earnings must drive stock prices  According to multexinvestor.com the S&P500 will have real earnings of $45 in 2002. At a high P/E ratio of 25, that results in a year end target of 1125. Today (3/12), the S&P500 is at 1165. How strong is the earnings outlook?  Remember, earnings is tied to sales by virtue of its current positive correlation

20. Conclusions!? Who knows? This is just one take on current conditions! Other analysts will have different opinions One thing is certain, its been a long wait since we’ve hit a new high in the S&P 500! This is what makes investing such a challenge!