The economy grew even faster than expected in the 3Q.  The Commerce Department reported that GDP rose at an annual rate of 4.0% in the 3Q, up from its previous estimate of 3.1%.  Most of the other economic news was positive last month as well.  However, on December 6, the government reported that unemployment jumped back up to 6% in November.  This is typical of an economy that is recovering slowly with ups and downs along the way.

The Bank Credit Analyst has released its forecasts for the next year.  They are more optimistic now than they have been in several months.  They now believe the Fed is taking the deflationary threat seriously enough, and they believe Greenspan will do everything in his power to keep deflation at bay.  They also expect more fiscal stimulus from the Bush administration early next year.  All of this should be good for the economy, but BCA still expects only slow growth next year.  More details inside.

Stocks rallied for eight consecutive weeks, before closing slightly lower in the first week of December.  The S&P 500 gained apprx. 20% and the Nasdaq over 30% from their October lows.  BCA recommends adding to equity positions on setbacks just ahead, but they advise doing so only using “market-timing” strategies.  Icontinue to recommend Neimann, Potomac and Hallman &McQuinn - all of which are market-timers - for your equity portfolio.  They have all beaten the market significantly this year.

Bonds have taken it on the chin over the last few weeks as interest rates inched higher.  BCA continues to recommend below average holdings of bonds, especially Treasury bonds.  Despite the recent shake-up in bonds, Capital Management Group , our high-yield bond timing Advisor, is up almost 9% this year in their unleveraged program.  I continue to highly recommend CMG for your bond holdings.

I have prepared a new SPECIALREPORT on Market-Timing.  In the new 12-page Report, I discuss the basic methodologies behind market-timing, ways you can use market-timing and the market-timing strategies I prefer.  You can get the Report at www.profutures.com or call 800-348-3601.

[Editor’s Note :  This summary of BCA’s latest forecasts is a repeat of the information contained in my Forecasts &Trends E-Letter dated December 3. Since not all of our clients read the weekly E-Letters, I am including BCA’s latest thinking in the next several pages.  If you have already read this, you may want to skip to page 5.]

Introduction

In 1977, one of the smartest clients I've ever had introduced me to a research publication called The Bank Credit Analyst (BCA) www.bcaresearch.com.  BCA is a Canadian research firm which publishes forecasts on the US and global economy, the stock markets, interest rates and bonds, the US dollar and other major currencies, gold and periodically real estate.  Over the last 25 years, I have found BCA to be the most accurate of all the sources I follow when it comes to predicting major turns in the economy and the investment markets.  That is why I have been a continuous subscriber since 1977, even though their research is quite expensive.

BCA's original monthly research report (apprx. 40-50 pages) costs $995 per year.  BCA offers over a dozen other publications, ranging from monthly to weekly to even daily, and the cost to subscribe to all of their regular services is over $10,000 per year.  Despite the cost, for the last 25 years I have kept my clients abreast of BCA's latest thinking and forecasts in my monthly Forecasts & Trends newsletter and more recently, in these weekly F&T E-Letters.

BCA caters to large, sophisticated investors and institutions.  As such, they assume that their clients and subscribers are always invested in US stocks and bonds, as well as other investments from time to time.  As a result, they have only three investment positions in stocks and bonds: “above average” holdings, “average” holdings or “below average” holdings.  They assume that most investors have “core” holdings of stocks and bonds that they never sell.  This is true of most large investors and institutions.  A portion of their assets is essentially in a buy-and-hold mode, while another portion may be switched from one asset class to another as market trends dictate.

In this issue, we look at BCA's latest forecasts provided in their early December publications.  While BCA has been the most accurate research source I have followed over the years, when it comes to calling major turns in the economy and the markets, they are not perfect.  With that caveat said, here is their latest thinking.

BCA's Prior Forecasts

For the benefit of our many newer subscribers who may not be familiar with BCA, let me quickly summarize their forecasts and investment recommendations over the last couple of years to bring us up to the present.  BCA predicted the economic slowdown that has been upon us since mid-2000.  Yet unlike the gloom-and-doom crowd, BCA did not expect the economic slowdown to turn into a severe recession.  Even after the terrorist attacks of September 11, the BCA editors did not believe the US economy was headed into a severe recession.  In fact, quickly after 911, the BCA editors suggested that the US economy might surprise on the upside.  It has.

BCA has recommended below average holdings of US equities consistently over the last couple of years.  They were among those that warned in 2000 that the Nasdaq was a bubble waiting to be burst.  During that same period and up until the middle of this year, BCA recommended above average holdings of bonds.   In June of this year, BCA recommended that investors move from above average holdings of bonds to below average holdings.  They particularly warned that Treasury bond yields could be near a bottom and recommended that investors switch from Treasuries to high-quality corporate bonds for core holdings.  This latest call on bonds was arguably a few months early, but bond investors have certainly taken some hits in the last several months.

Also since the middle of this year, BCA has been warning that US monetary authorities were not taking sufficient actions to head-off growing deflationary pressures.  They warned repeatedly that the Fed needed to cut interest rates further, or else global deflation could spread to the US.  They actually called on the Fed to cut interest rates by 50 basis-points at the November FOMC meeting.   It is believed that several of the Fed governors (and perhaps even Alan Greenspan) read BCA regularly, and it appears they took BCA's advice when the Fed Funds rate was slashed 50 basis-points last month.

With that bit of background out of the way, let's now see what BCA believes is ahead for the US economy and the major investment markets.

BCA's Latest Thinking

I am pleased to report that the BCA editors had a more positive tone in their latest publications.  While the editors did not categorically rule out a second recession earlier this year, they never believed it was the most likely outcome.  Rather, they believed that the US economy would manage to stay in positive territory with slow growth throughout the year.  That has proven to be the case.  Now, they expect the moderate recovery to continue over the next year.  They say:

“A double-dip recession in the U.S. was never the most likely scenario, and recent data suggest that the odds [of a recession] have dimmed even further.  The Federal Reserve's aggressive pump-priming is sustaining buoyant housing activity, the corporate sector continues to gradually heal, the labor market is showing tentative signs of improvement and our estimates point to a rise in the composite leading indicators in November.  Meanwhile, the Republican sweep in the mid-term elections clears the way for additional fiscal stimulus next year.

The big issue for the U.S. economy in recent months has been whether or not the consumer would run out of steam before the corporate sector was ready to start spending.  Recent data support a moderately positive view.”

Specifically, BCA believes that unemployment may have peaked and will begin to decline slowly.  They also believe that the housing market will remain stable to buoyant and is not a bubble about to burst.  They believe that the worst of the corporate retrenchment has been seen, and that companies will slowly begin to increase investment spending.  Their proprietary advance indicators suggest a significant rise in the Index of Leading Economic Indicators for November.  That report will be released on December 19.

While the BCA editors were more positive in their latest reports, they are not expecting a robust economic recovery over the next year.  In fact, they believe it will be a slow, “sub-par” recovery, meaning that GDP growth will likely be in the 2-3% annual range in the next year. 

Deflation Is Still A Concern

As noted above, the BCA editors have repeatedly warned US monetary authorities to pay close attention to the deflationary threat over the past several months.  They cautioned that if deflationary forces were to set in, they would be very hard to reverse, as has been the case in Japan for a decade.

In their latest issue, the BCA editors say they believe Alan Greenspan and a majority of the Fed governors have gotten the message on deflation, and that they will not hesitate to slash rates further - even to zero if necessary - to prevent a deflationary trend.  While most market analysts predict that interest rates will be higher a year from now, BCA predicts that the Fed Funds rate a year from now will be either the same as today, or lower.

Alan Greenspan actually said recently that the Fed would even resort to buying up longer-dated Treasury securities if needed to get the economy growing and stave-off deflation.  For now at least, the BCA editors seem to believe that the deflationary threat in the US has subsided somewhat.  Of course, this assumes there are no more major terrorist attacks in the US; if that were to occur, then all bets are off.

Time To Increase Equity Positions

Probably a surprise to most of their subscribers, the BCA editors recommended moving from below average to average holdings of stocks and equity mutual funds in their early December issue.  However, rather than jumping in the market immediately, or all at once, the editors suggest buying on weakness during the days and weeks ahead.

The S&P 500 has gained apprx. 20% from its October low, while the Nasdaq is up apprx. 33% in the same period.  There have been three previous rally attempts since the markets peaked in 2000.  Each time, the rallies failed when the S&P gained apprx. 20%.  While they do believe there will be some corrections (downward price movements) just ahead, the BCA editors believe that stocks have bottomed, and that the current uptrend will be sustained this time around.  They say:

“All of the above trends suggest that the current equity market is on sounder foundations than it was back in July/August.  Another encouraging development is that the NASDAQ has closed above the key resistance level of around 1420.

The combination of improving economic data and more positive market signals suggest that downside risks in equities have diminished.  They have not disappeared altogether, but a neutral [average] rather than underweight [below average] stance can now be justified.”

Let me be perfectly clear here.  The BCA editors are NOT predicting a huge new bull market in stocks and equity mutual funds just ahead.  Rather, they are simply saying that they believe the equity markets bottomed in October, and this warrants increasing positions from below average to average.  Specifically, they say:

“A new secular bull market in stocks is not about to begin.  More likely, the market will churn about within a broad trading range as valuations gradually compress.   The market is no longer expensive and there is plenty of cash sitting on the sidelines.

As we have discussed in the past, the buy-and-hold era in the stock market has ended.  Average returns from stocks will likely be mediocre in the years ahead, and the only way to generate excess returns will be to play the cycles.  The current cycle should be one worth playing, and we recommend using periods of weakness to build positions back to neutral [average] levels.”

Let me clarify what that last paragraph means.  As stated earlier, BCA assumes that investors have “core” holdings in both stocks and bonds that they never, or rarely, sell.   That is a buy-and-hold approach.  (In a future issue, I will discuss professional asset allocation strategies specifically for such core holdings.)

What BCA is saying above is that the days of putting most of your money into an “index fund,” like the hugely popular Vanguard S&P 500 Index Fund, and hoping to make 15-20% or more a year, are OVER.

Specifically what BCA is saying is that to generate attractive returns in stocks over the next few years, it will be necessary to have a portion of your equity portfolio that moves into and out of the market from time to time.

This Is Called MARKET-TIMING

For years, Wall Street types, Investment Advisors and talking heads on financial programs said buy-and-hold was the only way to invest in stocks.  They said market-timing didn't work.  Well, that was then and this is now!  Ever since the mid-1990s, I have been advising my clients to have a portion of their equity portfolio in market-timing programs.  Now even BCA, which advises some of the most sophisticated investors in the world, agrees with me.

Conclusions

BCA expects the economic recovery to continue with GDP growth of 2-3% in 2003, assuming there are no more major terrorist attacks.  They expect the Fed to cut rates further in the months just ahead, in an effort to counter deflationary pressures.  The BCAeditors appear more confident than in recent months that the Fed will be successful in heading-off deflation in the US.  They believe that a year from now, rates will still be as low as they are today, or even lower.  This is quite a departure from most mainstream forecasts which project rates to be higher a year from now.

Despite BCA’s outlook for rates to remain low, they continue to recommend “below average” holdings of bonds, especially Treasury bonds.  They feel there is a good chance that T-bond yields bottomed in October.

BCA upgraded its equity recommendation from “below average” to “average.”   They suggest that investors increase their equity holdings over the weeks ahead by buying during periods of weakness which they expect to occur from time to time.

BCA once again made the case that investors should pursue market-timing strategies for most of their equity portfolio.  They believe equity returns will be muted over the next couple of years, so to enhance returns they suggest using market-timing.

Unfortunately, market-timing is foreign to most investors.  Most investors are not good at knowing when to get in the market or when to get out.  Plus, there are lots of different market-timing strategies and systems and dozens of professional money management firms that employ them.  Deciding which ones to use is difficult.

A New SPECIAL REPORT

Since the stocks markets turned sharply higher in October, we have had tons of questions and inquiries about market-timing.  A lot of people are now considering getting back into the market or adding to their equity holdings.  For that reason, I have prepared a new 12-page SPECIAL REPORT on market-timing.   As this is written, I am putting the final touches on the new Report, and it will be available on our website by the time you receive this newsletter.  Go to www.profutures.com and you will see the Report on our home page.

In the new Special Report, I walk you through the basic methodologies behind market-timing; I discuss the various ways you can use market-timing; and I tell you the market-timing programs that I prefer.  I also help you decide if this is something you can do on your own, or if you would be better off hiring a professional to do it for you. 

In conclusion, I agree with BCA that the stock markets will be cyclical over the next several years.  We're not going to return to the rip-roaring, 20-30% a year markets that we saw in the late 1990s.  Reaching your retirement or other financial goals is going to be tougher - it already is!

As a result, I highly recommend that you begin to educate yourself about market-timing.  I've done my best to help you along with my new Special Report, which you can download on our website www.profutures.com.  Or, if you don’t use the Internet, call us at 800-348-3601 and we will mail you a copy.  The Special Report will be available free of charge. 

I continue to believe that most investors will be more successful at market-timing if they engage professional money managers, with proven track records, to do the market-timing for them.  Most of us are not good at doing this on our own.   We can provide you complete information on the market-timers we recommend.  Call us when you’re ready.

Consumer Debt Levels

US consumers are in hock up to their eyeballs, so we are repeatedly told.  For years we have been told that the US consumer was tapped-out, and that spending was about to fall off a cliff.  Yet consumers have continued to spend, despite 911 and despite the recession last year.  Still, every time a new report comes out showing consumer debt up, we get new predictions that consumers are going to retrench and send us into a new recession.

Take the latest report from the Federal Reserve, for example.  The Fed reported on December 6 that household wealth fell to its lowest level in seven years in the 3Q.  Household net worth fell 4.5% to $38.5 trillion as of the end of September.  The ratio of household net worth to disposable personal income fell to 4.9 in the 3Q, down from 5.2 in the 2Q.  This is the lowest reading since 1995. 

This latest report sparked predictions from the usual sources that consumer spending is going to dry up and send us into a new recession.  We’ve heard these same dire predictions for years whenever these reports were released, but somehow US consumers just keep spending.

There is no question that consumer debt has risen significantly in recent years, which has in part led to the fall in household net worth noted above.  The question is, has the decline in the net worth to disposable income ratio reached the point at which consumers really have to cut back significantly?  To answer that question, let’s look at some numbers.

According to the latest Fed report for the 3Q, US households had assets of $47 trillion, down 3.4% from the 2Q.  Most of that drop came from the 17% decline in household stock and mutual fund holdings in the 3Q, which fell to $6.5 trillion according to the Fed.  (Stocks have since recovered apprx. half of their 3Q decline.)

Household liabilities rose 2.2% in the 3Q to $8.5 trillion.  Of that $8.5 trillion liability, $5.8 trillion is in home mortgages.  Low interest rates and the surge in home refinancing over the last year have sent the mortgage component of household liability to the highest level since 1989.  Home mortgage debt, unlike credit card debt, is highly collateralized.

According to the Fed’s latest report, the average household net worth was $352,000 at the end of September, down from the peak of $412,000 in early 2000.  While $352,000 represents a drop of almost 15%, it is still higher than at any time  before 1998.

What’s So Ominous About That?

Let’s see. . . $47 trillion in assets and $8.5 trillion in liabilities doesn’t sound so bad, especially considering that $5.8 trillion of the liability is in the form of home mortgage debt which is fully collateralized.  Also, the fact that average household net worth has dropped from $412,000 to $352,000 is actually surprising in light of the grueling bear market in equities since the peak in 2000.  It could have been a lot worse.

The Bank Credit Analyst has argued for several years that consumer debt levels were not a huge threat to the economy.  With a few brief exceptions over the last couple of years, BCA has predicted that consumers would continue to spend, despite all the gloom-and-doom forecasts by others.  BCA has actually been much more concerned about the deflationary threat than a household debt crisis and a major retrenchment in consumer spending.

In their latest December issue, the BCA editors once again make the case that US consumers are not in a precarious financial position, and that there is still no reason to expect a major retrenchment in the next year.  In the paragraphs that follow, I will attempt to summarize BCA’s latest analysis on US consumer finances and their forecast for consumer spending in the next year or longer.

“The Democratization Of Credit”

The BCAeditors begin their latest analysis by stating that consumer debt levels have been rising since the 1950s, and that commentators have expressed worries over this trend ever since that time.  They attribute this to what they call the “democratizing of credit.”  Credit has become increasingly available to consumers over the last 30 years, now including many who could not get credit in the past.  The proliferation of credit cards  has made it easier than ever for consumers to take on debt. In more recent years, many retailers - including those that sell durable goods - have gone to “no interest” financing, another reason why consumer debt continues to rise.   Even automakers have gone to no interest financing. 

Finally, due to low interest rates, we have seen a record boom in home purchases in recent years.  Americans who never dreamed of owning a home have been able to do so in recent years due to falling interest rates and creative financing.  The boom in housing has played a key role in the economic boom over the last 20 years, and especially in the last few years.  The strong housing market helped us avoid a more severe recession in 2001.

The question is, has the rise in personal debt reached a precarious level?  Is it the next bubble to burst?  BCA argues that it is not a crisis.  They say:

BCA also points out that the USsaving rate has increased over the last year.  After falling to a new record low in 2001, the personal saving rate has recovered to near a 4% annual rate in 2002, according to the NIPA.  The low saving rate is another issue that the gloom-and-doom crowd harps on, but as predicted by BCA in May 2001, the savings trend has reversed in the right direction.

Not The Prevailing View

I’ll bet you haven’t heard an analysis of the consumer debt situation like the above anywhere else, except when I have written about it in the past.  Every time we see a report on consumer debt, there is the usual clamoring that personal debt is at an all-time high, and consumer spending is set to fall off a cliff, leading to a new, severe recession.  Obviously, BCA’s view is quite different, but then what else is new? 

BCA is quick to point out that there is one potentially dangerous flaw in their analysis of the consumer debt situation.  If housing prices were to drop sharply, then their relatively benign view of consumer debt would be incorrect.  With over 70% of household debt  in home mortgages, a sharp drop in home values would indeed send public confidence into a funk, and consumer spending would indeed retrench, perhaps causing a new recession.  However, the BCAeditors do not believe that the housing market is a bubble ready to burst, and as stated earlier, they believe interest rates will remain low for the next year, thereby supporting home prices.  Obviously, this is one key area of the economy that we should keep a close watch on.

Conclusions

Clearly, the latest forecasts and analysis from BCA are more optimistic than what we read and hear in  most other places, especially in the newsletter world.  They expect the economic recovery to slowly continue, interest rates to remain low and the housing market to remain generally firm.  They believe that while consumer debt levels are high, they are not at a critical point, assuming housing prices do not fall sharply. 

As noted earlier, the BCA editors believe the stock market has bottomed and advise adding to equity positions on weakness.  They recommend market-timing strategies, and we can certainly help you with that. 

You may, or may not, agree with BCA’s latest analysis.  There are certainly arguments to the contrary.  And I must emphasize again that BCA’s optimism assumes that there are no more major terrorist attacks in the US.  As I stated at the beginning, BCA has been the most accurate forecaster I have followed over the last 25 years.  They are not always right, but I don’t bet against them.  Let’s hope they are right again.