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4/8/2010 9:34:20 AM Eastern Time

Fed Heads Chime in…All at Once
By Research Group

By: Brian Sozzi, Research Analyst

Yesterday sure felt like one big Federal Reserve reunion. I would compare Paul Volker, Alan Greenspan, and Ben Bernanke all taking center stage to Joe DiMaggio, Don Mattingly, and Derek Jeter standing on the field for opening day ceremonies at Yankee Stadium. You could just feel the nostalgia in the air. But warm, fuzzy moments aside, I am unsure if what these three Fed honchos said was music to the ears of the markets.

Paul Volker

* Time served at Fed: 1979 to 1987
* Claims to fame: stomping out inflation; one of the tallest lawmakers outside of Abraham Lincoln

Overview of Comments

This isn't the first time that Volker was quoted as being for a valued-added tax (commonly referred to as a VAT). The man appears to say and do things that others may want to say and do but simply don't. Volker not so quietly defended his stance on a VAT, stating that it would not be as detrimental to economic output as many perceive. To that, I say hogwash. I have included my publication on a VAT from December 2009 so you can decide for yourself if Volker is inhaling too much cigar smoke when pounding the table on this foreign-esque tax.

Alan Greenspan

* Time served at Fed: 1987 to 2006
* Claims to fame: free market advocate, well versed in some form of the English language, cool nickname ("The Maestro")

Comments to Financial Crisis Inquiry Commission

* "Regulators will always miss a crisis."
* "In 1998, we were aware of the lending problems but we only make the rules we don't enforce them."
* "We are a creature of Congress."

Whenever I am in search of new verbiage I seek out Greenspan's testimonies (which could be watched on YouTube) or rehash older written presentations. Undeniably, the man at 84 years old is still super sharp. However, I think that he is doing a poor job of defending his legacy. The bottom line is that low interest rates led to financial innovation which in turn led to increased profits by financial firms which in turn led to…the list goes on for a while.
In the end, the economic meltdown of 2008/2009 calls for a complete regulatory overhaul, perhaps starting at the Federal Reserve that goes beyond stripping them of consumer protection powers. If these people were unable to spot the risk in the financial system and act upon it, does someone need to be overseeing the Fed more closely? I never thought I would say this, but is an independent Fed even viable in this day and age of market complexities? Food for thought I suppose.

Ben Bernanke

* Time served at Fed: 2006 to present
* Claims to fame: saved the financial system, no sign yet of inflation fighting credentials, snazzier dresser relative to the other two guys

Comments at the Dallas Regional Chamber

* "Fortunately, today the financial crisis looks to be mostly behind us and the economy seems to have stabilized and is beginning to grow again."
* "Indeed I would argue that no financial instrument counted as regulatory capital should be allowed to receive any protection from losses."
* "My best guess is that economic growth, supported by the Federal Reserve's stimulative monetary policy, will be sufficient to slowly reduce the unemployment rate over the coming year."

Very interesting takeaways from this set of comments. Regarding the second bullet, I praise Bernanke for stating the obvious; both bondholders and shareholders need to feel the pain if a financial institution hits the skids. Lenders of capital shouldn't be absent of risk; risk is an essential component to investing. On the third bullet, does it mean that (A) current interest rates will be sustained throughout 2010 or (B) interest rates at 1.0% are still stimulative, so incoming data could support higher rates if required to curb inflation. To this end, it's a tough call. I believe that the statement was designed to not box the Fed in, essentially mirroring the "extended period" language in the policy announcements.

Areas of Interest
$21.0 billion of 10-year notes was met with solid demand yesterday afternoon. Importantly, the yield clocked in at 3.90%, below the 4.00% mark that has been viewed as a tipping point for the broader market. The bid to cover ratio was 3.72 times, above the normal 2.87 times.

How a VAT Works (published by me in late December)

Applied in about 130 countries worldwide, a "value-added tax" (VAT) is known as a consumption tax levied on any value that is added to a product. At the moment, such a tax is not implemented in the U.S. Rather, we have a state and local sales tax structure that is linked to the fiber of our nation, spending. As a means to pay for the towering U.S. deficit brought about by war, financial bailouts, and healthcare reform a VAT is being chatted up in the depths of Congressional offices. Politicians would no doubt find it next to impossible to garner support of a VAT by their constituents, but given the rise in government debt and structural changes to our economy (people saving more) it may be a difficult pill that may have to be swallowed by, none other than the U.S. taxpayer.

A VAT ultimately penalizes consumption and encourages savings. Many supporters (including Nancy Pelosi and increasingly, inflation fighter Paul Volker) believe adoption would immediately provide a boost to the U.S. economy as consumers rush to the malls to purchase goods prior to a rise in final prices. This activity is sort of like what happened in the U.K., where consumers flocked to High Street post Christmas to buy merchandise before the VAT returned to 17.5% from its residence at the time of 15%. Note those tax percentages! They are miles and miles away from existing U.S. state and local sales tax rates. I digress. Here is a good common man example of how a VAT works.

Say you agree to pay cash to a plumber to install a new toilet in the bathroom. By agreeing to pay cash, under the current U.S. tax system, the government receives no tax on the value offered by the plumber. It's a win-win for the plumber and homeowner, though deceptive in its own right. Assuming a value-added tax, the plumber and homeowner would receive no benefit by agreeing to a cash transaction for service rendered as:

* The tools bought to install toilet would have been taxed through the production chain.
* The raw materials used to complete the job would have been taxed through the production chain.

The end user of the plumber's services, the homeowner in this case, would be charged a higher price as the plumber is being taxed on each stage of production for the items he uses to finish the job. Another example is a pair of jeans which would be taxed at each state of production. The materials source would pay a tax. The manufacturer would pay a tax. The distribution company would pay a tax. The retailer would pay a tax. When all is said and done, a pair of jeans once being sold for $15.00 may now cost $18.00. For a low-income consumer, that $3.00 differential could be a tipping point, and lead to a lost sales for a retailer and a deeper profit killing markdown down the line.

Potential Impact of VAT

* Economic cost to businesses: more tax services needed, updates computer accounting technology needed, lost sales as consumers save their income.
* Opportunity cost: small businesses would be devoting more effort to tax collection and planning, time that could be better served working on expansion strategies that create jobs.
* Distortions in the marketplace: once consumers conclude the buying process prior to VAT implementation, demand for goods and services could fall off precipitously.
* Higher prices for the consumer: costs of the program and increased risk of carrying inventory that potentially goes unsold due to reduced demand will be reflected in much higher retail prices. Discount retailers, already feeling the impact of rising healthcare costs, would have their low price business model come under heavy attack.
* Cost to stock market participants: lower equity valuations as the market adjusts to account for reduced consumption (as seen in revenue growth rates and net profit margins)

Conclusion

According to a paper written by Leonard Burman in the Virginia Tax Review, a 25% VAT would pay for healthcare reform, balance the federal budget, and exempt millions of families from the income tax while slashing the top rate to 25%. The penalties you ask? A gallon of gasoline would jump close to $5.00 and a $5,000 kitchen remodel would now run nearly $6,500.

While I can appreciate the need for the government to find new revenue sources to foster greater fiscal health for the country, there must be a less penalizing means to that end. Maybe the government could slash taxes to spur investment by businesses and consumption by households. It's just a thought.

Is this a Positive Month or is There More Items Worthy of Attention?

Following 2009, a year marked by balance sheet rehab by U.S. consumers and subsequent negative comparable store sales by the nation's retail outfits, it's a breath of fresh air to observe the positive March 2010 comps that are being reported. For a select few retailers, comps turned positive in December 2009 only to accelerate into the spring months. That said, let's not overlook the sales bases that retailers are cycling; for our specialty apparel sector coverage comps were negative each month of 2009, with many double-digit percentage results scattered about. Our discount retail sector coverage, on the other hand, comped negative up until September 2009 as controlled spending and consumables deflation were present.

This morning, we are seeing solid March comp readings across the retail landscape. Most companies are surpassing consensus comp estimates, but interestingly enough are falling short of the more bullish sell-side estimates (such as 13% or over call outs). We anticipated this could transpire and advised clients to approach the sector with caution going into the results. Keep in mind that promotions are still the order of the day in retail as a means to bring in traffic. The pent up demand may be there, but in order for it to be unleashed it needs to be enticed. The promotional strategies by retailers, ultimately, cap the upside potential to comps that can be realized from an increase in traffic and conversion.

Early Winners
* (HOTT) - Hot Topic (enacted special dividend, enacted annual divided, and beat on comp; we reiterated our Buy rating and price target on April 6)
* (WTSLA) - Wet Seal
* (LTD) - Limited Brands
* (COST) -Costco (excluding gasoline and currency, comps were reasonable but we sense slight disappointment by the market)
Disappointing
* (ANF) - Abercrombie & Fitch (pricing strategy continuing to weigh on comps, which missed consensus on a very easy year earlier comparison; we downgraded our rating on the stock to Sell on April 7)
Monthly Drivers
* Early arrival of summer weather
* Spending by those that remained employed in 2009 (aka releasing of pent up demand)
* Early arrival of Easter holiday (calendar shift seems to have benefited specialty retail by 1% to 3%)
Other Notes
* Many companies sidestepping 1Q10 guidance issuance; April is an unknown as results will be hampered by Easter shift

We will have further color on the results posted on our website this afternoon.

Long Idea: KLA-Tencor Corporation (KLAC) @ $31.63
Click here to view the trading alerts that followed this recommendation

Trading Parameters
Entry Price	Entry Limit	Stop Loss	Trading Target	Target	Long-term Target	Options
$31.63	see comments	$28.00	$36.00	$37	N/A	N/A
Options Trade Parameters
Type	Option Symbol	Entry Price	Strike Price	Expiration Date
Call	KCQ100918C00031000	$2.80	$31.00	9/18/2010

BACKGROUND: KLA-Tencor Corporation provides process control and yield management solutions for the semiconductor manufacturing and related microelectronics industries. It offers equipment comprising patterned and unpatterned wafer inspection, defect review, and classification; reticle defect inspection; packaging and interconnect inspection; critical dimension metrology; pattern overlay metrology; film thickness, surface topography, and composition measurement; measurement of in-chamber process conditions, wafer shape, and stress metrology; computational lithography tools; and yield and fab-wide data management and analysis solutions. The company also provides products that serve the LED, data storage, solar, and other industries; and semiconductor mask and wafer inspection and metrology systems. KLA-Tencor offers its products in the United States, Europe, Israel, Japan, Taiwan, Korea, and the Asia Pacific. The company was founded in 1975 and is headquartered in Milpitas, California.

SKINNY: Our long idea this morning is KLA-Tencor Corporation (KLAC) as we believe the company will continue to improve revenues and gross margin. The company's performance over the past couple of quarters clearly indicates that the worst is well behind the company (and industry as a whole), and although industry capacity is still plentiful, it is depleting. Moreover, foundries are investing aggressively for their transition to 32-nanometers and for capacity additions at 45-nanometers. So far the majority of KLAC's revenue growth has been driven by technology builds, and this still leaves room for demand driven growth to occur in the second half of 2010. We believe that semiconductor industry utilizations rates will approach high levels, increasing the likelihood of capacity expansions. However, technology buys will continue; as memory makers increase production at the lower nodes, they will run into technical challenges that will require more inspection steps in the manufacturing process. KLAC has already increased its exposure to the memory industry and stands to benefit from this. We see shares of KLAC moving to $36.00 and then to $37.00; use $28.00 as a stop loss.

Analyst Coverage
Credit Suisse Reiterated to Neutral	Caris & Company Reiterated to Average	FBR Capital Reiterated to Market perform