The big news from 2002 was that the US economy grew faster than most economists and market analysts predicted.  Gross domestic product grew at an annual rate of 5%, 1.3% and 4% in the first three quarters and is expected to have been around 2% in the 4Q.  That’s an average of 3% for the year, which was well above most expectations.  There was no recession as the gloom-and-doom crowd all but promised.  As for 2003, we should expect to see continued economic growth with another 3% year, assuming there are no more serious terrorist attacks in the US.

Giving credit where credit is due, the always bearish gloom-and-doom crowd got it right  with regard to the equity markets in 2002.  The S&P500 fell 23%, the Nasdaq fell 38% and the average equity mutual fund lost 22% in 2002, marking the third consecutive losing year.  At this point, it remains to be seen if the bear market ended last October or if lower lows are yet to come.  Most of my sources believe the markets will be in a broad trading range in 2003 but will end the year higher than where they are today.  This outlook continues to suggest using market timing strategies for your equity investments.  You can get my new 12-page SPECIALREPORT on Market-Timing at www.profutures.com or call 800-348-3601.

Bonds were one of the few winners in 2002.  The average long-term bond mutual fund gained 7.9% for the year according to Lipper Analytical Services.  But the question is, will interest rates continue to fall this year?   It is possible, of course, but I would not buy bonds at this time.  Gold prices soared briefly above $350 in December on war fears, soaring oil prices and the falling dollar.  This is another market Iwould not chase now.

In The Bank Credit Analyst's latest report, "Outlook 2003," the editors provide a very interesting and educational analysis on the supercycle of debt in the US and when it may come to an ugly end. They begin at the end of WWII and summarize US economic and monetary policies up to the present, with some forecasts into the future. In the pages that follow, I have reprinted much of this analysis from BCA. This is one of the best economic and monetary summaries I have ever read, and it is written in terms most anyone can understand. Be sure to read it, and especially my analysis on pages 7-8. I trust you will find it very insightful.

Introduction

At the end of each year, BCA publishes a special issue which gives their forecasts and analysis for the new year.  In the latest “Outlook 2003,” the BCA editors included both a look back at the past and a look several years out into the future.  The text which follows is, I believe, one of the best summaries of US economic and monetary policy over the last 30-40 years that I have ever seen.  You have my permission to photocopy or reprint this issue to share with relatives and friends.

The BCA editors take us back to the period just after the end of World War II and show us how the “Supercycle of Debt” began in the US.  They walk us through the various economic cycles since then and point out how US policymakers elected to deal with the ups and downs in the economy, including the mistakes they made.  Specifically, they point out that, unlike the pre-WWII era, debt burdens were never allowed to be completely washed-out during recessions.  As a result, each economic upturn began with higher debt levels than the previous one, and we now find ourselves at record levels of public and private debt.

This Supercycle of Debt, the editors believe, will come to an ugly end at some point with a debt deflation and a possible financial crisis.  This is the scenario the gloom-and-doom crowd has argued was just around the corner for the last 25 years, that I know of.

The BCA editors believe, however, that the debt deflation scenario is still several years into the future.  They believe that the recent aggressive monetary and fiscal policies will prevail over the current global deflationary environment.   They are quick to point out, however, that any serious negative shocks - such as more serious terrorist attacks in the US - could accelerate the time-table dramatically. 

So, jump right in and read this excellent piece of analysis.  I hope it is as helpful as I expect it to be.  My thanks, as always, to Martin Barnes at BCA.

QUOTE from BCA “Outlook 2003”

Editor’s Note : The text which follows is quoted verbatim from BCA’s “Outlook 2003” published in late December 2002.  The format for this annual report is a Q&A with the BCAeditors and “Mr. X” who is reportedly a long-time BCA subscriber.  The BCA text quoted begins with the paragraph below and ends at  the bottom of page 6.

“The Supercycle of Debt & Illiquidity

The post-WWII period has been an era of tremendous prosperity and growth, interrupted by relatively few short-lived periods of economic decline. Compared to the pre-WWII years, the economy is much more stable, largely as a result of the growth of the welfare state and the abandonment of the gold standard. The cost of this stability is that there is no longer the regular purging of financial excesses that used to occur during the frequent steep downturns that plagued the pre-WWII years, culminating in the Great Depression.

Once policymakers decided that they could smooth out the business cycle with fiscal and monetary policies, the economy embarked on a slippery slope of diminishing financial discipline, with rising debt burdens and declining balance sheet liquidity. Balance sheet excesses built up during the boom times and the authorities never allowed them to be fully unwound during recessions. This meant that each new expansion began from progressively lower levels of liquidity (Chart 1)[shown on next page]. The greater balance sheet excesses became, the more painful any corrective process would be. So the stakes got higher each time, pushing the economy ever closer to a deflationary end-point. This is the essence of the supercycle process that we have written about over the years.

The supercycle has moved through several phases over the past few decades. For example, the abandonment of the dollar's link to gold in 1971 removed constraints on U.S. monetary policy. Thus, the creeping inflation of the 1960s blossomed into a full-fledged inflation outbreak in the 1970s. However, by the end of that decade, it was clear that inflation had to be reigned back in, and Fed Chairman Paul Volcker launched what turned out to be a 20-year struggle to achieve price stability.

Once monetary policy moved firmly onto an anti-inflation path, the authorities initially exploited fiscal policy as the tool of reflation, and the early 1980s witnessed the greatest-ever peacetime explosion in budget deficits. When even more stimulus was needed to shore up the economy, the dollar was pushed lower, following the Plaza Accord of September 1985.

By the late 1980s, it looked as if policymakers were starting to run out of room. The Wall Street crash of 1987 was a warning sign that the weak dollar had become a source of tremendous financial instability and was doing more harm than good to U.S. markets. Meanwhile, fiscal trends pointed to a looming debt crisis, forcing the government to shift back toward restraint in 1990, a trend that lasted until last year. Finally, even private sector debt burdens appeared to have reached a limit by the 1990/91 recession, with the worst banking crisis since the 1930s and the implosion of the junk bond market.

Against this background, we began to consider the possibility that the supercycle had reached a terminal phase because the authorities had run out of policy levers. We need not have worried. The supercycle process was given a new lease on life in the 1990s, but not because of new policy stimulus. This time, the impetus came from the excitement about the information technology (IT) revolution that fed one of the greatest equity bubbles of modern times. Of course, policy played some role with the Fed providing enough liquidity to keep the bubble alive. Japan's extended downturn, oddly enough, also played a role. The combination of Japan's chronically high saving rate and depressed economy provided a steady flow of cheap capital to the rest of the world, and the U.S. in particular.

The 1990s IT bubble infected the whole economy and encouraged a major ratcheting up in leverage in both the consumer and business sectors. Of course, by definition, all bubbles burst, but that did not mean the end of the supercycle. Having been through an extended period of restraint, both fiscal and monetary policy were in a position to resume their earlier role by reflating massively in order to prevent a disastrous balance sheet retrenchment.

Mr. X: So where are we now in the supercycle process?

Editors: The authorities are pulling out all the stops in their attempt to prop up the economy. The Fed has cut rates to the lowest level in more than four decades and has made it clear that it is prepared to run the printing presses flat out in order to prevent deflation from taking hold. Meanwhile, last year saw the biggest-ever swing from fiscal restraint to stimulus, worth 2.4% of GDP. With the Republicans now in full control of Congress, we can expect more federal stimulus this year. Globally, real short rates are close to zero.

The ratio of U.S. federal debt to GDP virtually doubled from 25% to almost 50% between the early 1980s and early 1990s. It is now back to 34%, and on current legislation the Congressional Budget Office predicts it will be fall to 15% during the next decade. In practice, the authorities will not hesitate to push the debt ratio back to 50% or higher, if that is necessary to support growth.

As far as the Fed is concerned, its main objective at the moment is to prevent the U.S. from falling into a Japan-style debt deflation. That is what the supercycle is all about - preventing such an outcome. Remarks by Fed Chairman Alan Greenspan and other Fed policymakers have emphasized that the Fed is prepared to go to extraordinary lengths to pump in liquidity, and it will not be constrained even if nominal short rates fall to zero.

Mr. X: How confident are you that easier monetary and fiscal policy will work?

Editors: Easier money has worked so far via boosting housing activity and keeping the equity market stronger than it would have been otherwise. Low rates have also made it easier for auto companies to boost sales by offering cheap financing deals. The fact that the economy suffered only a mild recession despite bursting a major asset bubble is largely a testimony to the power of easy money, although some timely tax cuts also helped.

Low rates have not done much to improve confidence in corporate boardrooms. Thus, it is possible that monetary policy might fail to boost demand if there is a negative shock, such as another terrorist attack in the U.S. At that point, the government would presumably open the fiscal purse strings even wider. If that was still not enough, there could be explicit efforts to push down the dollar.

It is hard to believe that the combination of quantitative monetary easing, fiscal stimulus and a weaker dollar would fail to boost the economy. Policy has been impotent in Japan, but policymakers there have not been running the monetary printing presses full out, and they have shied away from pushing the yen down. Moreover, much of the fiscal stimulus in Japan has been misdirected, compromising its economic impact.

The bottom line is that the supercycle is alive and well. The U.S. has the means and the will to unleash massive stimulus if necessary during the next year and beyond. However, this time, the stakes are being raised even higher because consumer balance sheets showed no improvement at all during the recent recession. The implication is that the deflationary risks will be even greater during the next economic downturn.

Mr. X: This leads nicely to the issue of debt burdens. As I noted at the outset, I am concerned that the recent sharp rise in private sector debt leaves the economy dangerously vulnerable in the event of any negative shocks. You seem to have confidence that the authorities will be able to save the day, but I am not totally convinced. What would cause you to change your mind?

Editors: We agree that rising debt burdens increase the economy's vulnerability. Moreover, at some point, the U.S. will reach the end of the road in its ability to keep leveraging up, and at that point the outlook will be very ugly. However, current very low interest rates significantly reduce the risks because they help to keep debt servicing burdens down. Clearly, if interest rates were to rise before the economy was on a sound footing then it could be disastrous, but that does not seem likely. The Fed will not hike rates until it is absolutely sure that the economy can withstand it.

One positive sign is that bank loan delinquency rates have been relatively flat in the past year, and are far below the levels of the early 1990s. It would be worrying if these spiked higher given that there is very little scope now to give additional rate relief.

Alarm bells would also ring if U.S. monetary growth dropped to a low level, as that might signify a developing liquidity trap. While money growth has slowed sharply from very rapid levels, it has not fallen into a danger zone.

Finally, it will be important to keep an eye on the health of the housing sector given that mortgages account for about 70% of household sector debt. Financial problems quickly erupt if there is an implosion in the value of the asset that collateralizes most of the debt. That was the big problem in Japan. In the U.S., the equity meltdown did not do too much damage because, even at its peak, margin debt accounted for only 4% of total household debt. A housing collapse would be much more dangerous. Fortunately, the Fed understands this very well, and this is why it will be cautious about raising rates.

Mr. X: You have written a lot in the past year arguing that the financial position of consumers is not that bad. Some might see that as a complacent attitude.

Editors: We have published quotes dating back to the 1950s that have expressed deep concerns about overindebted consumers, so these worries are not anything new. What is often forgotten is that there has been tremendous democratization of credit in the past few decades that means that credit is now available to many groups of people who had been denied access in the past. In other words, a rising debt-to-income ratio partly reflects more people taking out mortgages and owning credit cards. It is not simply the same people getting ever deeper into hock.

It is also misleading just to look at the debt side of the balance sheet. A rising homeownership rate implies more people are shifting from renting to owning a home. This boosts debt ratios, but there is also now an asset, and increased savings as mortgage principal is paid down. Meanwhile, these new homeowners may even be better off in a cash flow sense if their mortgage payments are less than their earlier rent costs.

Clearly, the financial position of consumers is not as good as it was at the peak of the boom. There has been huge destruction of paper wealth and consumers will need to save more going forward. However, we do not see any evidence that some crisis level of debt has been reached. As we noted, it is not sustainable for debt to rise faster than incomes indefinitely, and a painful adjustment will at some point be inevitable. But it could be several years away.

Mr. X: It seems to me that one of the solutions to the problem of too much debt is to create more inflation, as occurred in the 1970s. Increased inflation is a very effective way to bring relief to debtors because it lowers real debt burdens. Is that not what will happen given that policymakers are opening the monetary taps?

Editors: Yes, that seems quite likely, but it is probably several years away. The current aggressive monetary and fiscal response to deflationary risks will sow the seeds for inflation down the road. It should be a gradual transition, even though there could be quite violent cycles during this period. The structural forces behind deflation will be with us for a while...

...We don’t want to leave you with the view that we think inflation is about to erupt again [in the near-term]. The point is  that a major policy shift is underway that will have important longer-run [inflationary] effects. Deflation will be the main focus of attention in the next couple of years, but under the scenes, the conditions will be falling into place for a shift in trend.

Mr. X: Let’s turn now to the outlook for the economy for the coming year...

Editors: In our discussions a year ago, we argued that there would be a moderate U.S. recovery during 2002, largely because of the aggressive policy stance. However, this view was challenged during the year when fears of a double-dip recession became widespread. Thus, the big surprise for many has been the fact that the U.S. economy remained resilient, especially relative to the weak performance in Japan and the Euro zone. The willingness of the U.S. consumer to keep spending and to keep buying houses has been the savior of the global economy.

As we look ahead to 2003, there is a good chance that it will be more of the same. In other words, the U.S. economy will continue to defy those who keep looking for a slide back into recession. Importantly, as we discussed, the U.S. consumer is in better financial shape than widely perceived and spending should continue to grow, albeit at a slower pace than this year. Meanwhile, U.S. companies have already cut spending to the bone and a recovery is in prospect as confidence slowly improves from its current rock-bottom level. In fact, capital spending could easily surprise on the upside as companies have been under-investing during the past year and net capital stock is now falling...

. . .Editors’ Conclusions: Our main points are:

•The supercycle of debt is intact with policymakers prepared to reflate aggressively in order to prevent a debt deflation from taking hold. This pushes an eventual balance sheet retrenchment [debt deflation] further into the future.

•A moderate economic recovery is likely in the U.S. and in most overseas economies during the coming year. The emerging Asian economies will continue to perform well. Sentiment toward the global economy should improve during the year.

•There are signs that deflationary pressures have peaked, but deflation will remain a powerful force in  the next year or two. This is why monetary policy will stay very easy. The Fed will not raise rates in 2003 and the ECB [Europe] could cut again. Longer run, inflation is likely to reappear as a concern.

•A tough pricing environment will create a headwind for profits in all regions, but even a mild earnings recovery will allow equity prices to move higher, given buoyant liquidity conditions.

•The cyclical picture for stocks has improved, but valuations and investor disillusionment make a major bull market unlikely. History suggests that burst asset bubbles are followed by a broad trading range that can last for many years. A neutral [average] equity weighting is recommended.

•European and emerging market equities should outperform Wall Street. The Asian markets look the best bet. Japanese stocks are primed for a bounce, but it is a high-risk market. Our global sector strategy emphasizes areas that will benefit from reflation and where earnings are set to rise. Oil and gas stocks should also do well. We are underweight [below average in]technology.

•The low in bond yields has probably been seen,  barring a major economic or financial shock, and we recommend below-average bond positions. Fixed-income portfolios should focus on corporate bonds in both the U.S. and Europe. Emerging market bonds are also attractive.

•The dollar is headed lower on a multi-year view, but it will be a gradual process given the weak condition of overseas economies. Any dollar weakness will be mainly against the euro and commodity currencies rather than the yen.

•The grinding bull market in commodities should continue, helped by strong demand from Asia. Oil prices could surprise on the upside, even after the Iraq situation is resolved. Longer run, a shift toward hard assets will benefit commodities, including gold.

•Real estate should continue to benefit from buoyant liquidity conditions and distrust of equities...

•...There is a lingering risk of a financial accident. On the other hand, positive surprises could be a stronger than expected economic rebound, improved political stability in the Middle East, and a (rare) year without any major economic or financial shocks.”   
ENDQUOTE

Interpreting BCA’s Latest Forecasts

Basically, what you have just read is really two forecasts from BCA - a short-to-medium-term forecast covering the next 2-3 years - and a longer-range forecast beyond that point.  I will attempt to clarify both.

The first forecast suggests that the economy will continue to recover over the next 2-3 years.  We aren’t headed back into the boom times of the late ‘90s, but economic growth should average 3% and probably a little better.  Stocks are likely to be in a broad trading range with a mildly upward tilt.  Interest rates will remain low this year and until there are clear signs that the economy can handle any interest rate hikes.

The long-range forecast is not so benign, however.  As BCA pointed out, the massive monetary (and soon-to-be-fiscal) easing over the last year and a half, with  more to follow, is sowing the seeds for a new round of inflation.  Inflation could turn higher sometime in 2004 and almost certainly by 2005.  At that time, the BCA editors have no doubt that the Fed will resume fighting inflation as they have for the last 20 years.  This fight could lead to the next recession.

Unwinding The Supercycle Of Debt

BCA did a masterful job of describing and explaining the massive build-up of public and private debt over the last half century.  Because policymakers have had more tools to smooth-out the economy and mute recessions, unlike in the pre-WWII period, the debt has continued to soar higher and higher.

BCA’s concern is that in the next significant economic slump, the Fed and the government may not have sufficient policy levers to avoid a serious recession and perhaps even a debt deflation and a related financial crisis.  The following BCA comments should be taken very seriously.

“The implication is that the deflationary risks will be even greater during the next economic downturn... Moreover, at some point, the U.S. will reach the end of the road in its ability to keep leveraging up, and at that point the outlook will be very ugly.”

This is BCA-speak to warn that they are very concerned about the longer-term outlook.  The editors pointed out very succinctly and more than once that they are very confident the Fed and the government have the firepower to head-off deflation in the near-term.  However, whenever the next significant economic slowdown occurs, they are very concerned that a debt deflation could unfold.

A debt deflation is not a pretty thing.  In Texas, we know.  In the ‘80s, we had the banking and savings and loan crisis.  Real estate and related prices and oil plunged as did the Texas economy.  It was indeed “ugly” as the BCA editors suggest above.  It would be even worse were it to occur on a national scale.

Maybe I’m Wrong

You may have read a much more benign message in BCA’s analysis on the previous pages regarding what may happen following the next 2-3 relatively positive years.  Actually, some of the people on my staff did not interpret BCA’s Outlook 2003 nearly as negatively as I did regarding the long-range outlook.

So, I could be wrong.  But having read them continuously for 25 years, I think I understand BCA-speak pretty well.  And I think this is the first warning of more to come about the threat of a debt deflation in our not-too-distant future.

The Terrorist Caveat

Just like everyone else in the forecasting business, the BCA editors stress that if there are more serious terrorist attacks in the US, then all bets are off.  Another serious attack could throw this economy right back into a recession, or worse.   Additionally, if home prices were to  plunge as a result of more terrorist attacks, this could easily send us into a debt deflation.  But short of more terrorist attacks, BCA is solidly positive about the next couple of years at least.

How To Invest In This Environment

Many investors are paralyzed today, with lots of money on the sidelines earning next to nothing because of fears about the economy and/or the markets.  Yet the fact is, no one - not even BCA - can say for certain that we are going into a debt deflation or a financial crisis.  It may or may not happen.  The US has managed to withstand numerous financial shocks without falling into deflation over the last 20-30 years.  So, I do not recommend you formulate your investment strategy based on the possibility of a debt deflation some years down the road.

Besides, if BCA’s forecast is correct, we should have 2-3 more years with some good opportunities to make money.  You might be asking, If the stock market is going to be in a broad trading range with a mild upward bias, and bonds may be topping out, how then are we to make money during the next 2-3 years?  Good question.  Fortunately, I have some answers.

Market Timing Programs

I may sound like a broken record about market timing, but please hear me out, especially given BCA’s forecasts for the next couple of years or longer.  As you know, we sponsor several equity mutual fund timing programs.  Of the programs we recommend, all were either fractionally higher to less than 10% lower in 2002 - as compared to the S&P 500 which fell 23.4%.  You may disagree, but Ithink being slightly higher or only modestly lower in 2002 is a real accomplishment!

With the stock markets expected to move in a trading range this year and possibly beyond, I believe this will be an environment where our market timers can really do well (no guarantees, of course). 

What About Bonds?

Here again, market timing.  Capital Management Group (CMG), our recommended bond timing Advisor, gained over 10% net of fees in 2002.  Their leveraged program did even better.  CMG has averaged 10.4% annually for the last 10 years, with a worst-ever losing period of only 3.3%.   I don’t know about you, but I would be tickled to earn 10% in bonds over the next couple of years (again, no guarantees)!

CMG’s minimum account size is only $25,000 for ProFutures’ clients.  We have very few clients who would not be suitable for CMG.  So, if you haven’t considered this program seriously, I strongly recommend you do so, especially given the outlook ahead.

Alternative Investments

We also sponsor several managed futures funds.  I am pleased to report that our older futures funds gained 11.7% to 13.7% in 2002, net of all fees.  These funds struggled a few years ago, before I took over the Advisor selection process. Now they are back on track.

We also have a special relationship with Campbell &Company which is today the largest futures Trading Advisor in the world, with over $3 billion under management.  Campbell is one of the Advisors in our older funds, but we also have one program that Campbell manages exclusively for us.  In that program, Campbell gained 24.7% in 2002 for our clients.

Campbell recently increased its account minimum to $250,000 for its private funds and to $100,000 for its public funds.  However, ProFutures’ clients can access our Campbell managed program for only $25,000.  To my knowledge, we have the lowest minimum available anywhere to access Campbell today.

So, there are good opportunities, even in these unusual markets.  You just need to be in programs that can move in and out of the markets as need be.  You may also want to consider a futures fund.  We are one of the few firms that offer both market timing programs and managed futures.  Call us at 800-348-3601 for more information.

Many thanks & HAPPY NEW YEAR!