The Commerce Department’s final GDP report on 2002 shows the economy grew by 2.4% versus only 0.1% in 2001.  The latest Wall Street Journal survey of 55 leading economists shows the economy growing, on average, by 2% in the first half of this year and 3.5% in the second half.    Based on falling consumer sentiment at the moment, those numbers would seem optimistic.  The outcome will, of course, depend largely on how the war with Iraq goes, and as this is written (April 3), the time-table on the war is very uncertain. 

Most analysts I respect feel the war will be decided by the end of April, although there will be ongoing operations in Iraq for months to come.  If this is the outcome, and the war is ended without severe coalition casualties, I still believe the economy will recover gradually during the balance of the year.   The Bank Credit Analyst agrees.  More economic analysis inside.

The investment markets are gyrating on war news and are likely to remain choppy and directionless until the war winds down.  In stocks, I continue to believe this is a buying opportunity, and that equities will rebound if the war goes well.   Longer-term, most analysts Irespect believe that stocks will deliver disappointing results for the next several years.  If so, this definitely argues for market timing.

Treasury bonds and notes are over-valued due to war worries and should decline in value if the war goes well and the economy improves.  At this point, most of your bond holdings should be in a professionally managed portfolio that can either 1) go to cash if need be, or 2) switch among different types of bonds to enhance returns and/or limit losses.

Gold prices have plunged since early February when the yellow metal hit $390/oz.  Prices fell back to $325 in the latest week.  Gold share prices (XAU) were hit even harder and fell below the last major low in December.  I would continue to avoid these very volatile, high risk markets.

This month, I focus on high yield bonds (junk bonds) and a strategy to  participate in this market and enjoy the higher rates of return but with less risk  than you might think. 

Recovery Or Recession?

I continue to believe the most likely economic scenario is a continued mild improvement during the rest of the year.  The Bank Credit Analyst agrees.  But there is a lot that could change that outlook, and the latest slew of economic reports don’t look very encouraging.  Some of the disappointing news in March and early April is merely the result of the war with Iraq, and this is likely to change if the war goes well and ends relatively soon.  Let’s look at some of the latest reports.

As noted on page 1, GDP rose 2.4% in 2002, with 4Q growth of 1.4% (annual rate).  To the surprise of many, corporate profits rose 4.1% in the 4Q, the highest level in more than three years.  But the more recent reports were not so favorable.

The following reports are for February (latest data available): Consumer Confidence 62.5, down from 64.8 in January; Consumer Spending -0.4%; Retail Sales -1.6%; Durable Goods Orders -1.5%; Housing Starts -11%; Auto Sales -3.4%; and Unemployment 5.8% (unchanged).  Along with these reports, the CPI rose 0.6%, and PPI rose 1.6%, both up mainly due to rising energy prices.  About the only good news in February was Industrial Production which rose a modest 0.1%.

The first report we have for March doesn’t look good either.  The University of Michigan Consumer Sentiment Index fell to 75.0 in March, down from 79.9 in February - the lowest level in 10 years.  Consumer spending makes up over two-thirds of GDP.

While all of this sounds bad, much of it is the result of the build-up to and the beginning of the war.  The media led the public to believe the war would be a cakewalk, perhaps lasting only a few days.  That was never realistic, but many Americans bought into it anyway.  After only a week, we all knew the war would not   end so quickly.  This, no doubt, affected consumer confidence.  Confidence will remain low until it is clear that we have won the war.  This is nothing new.  The big question is what happens after the war.

The Media Continues To Be Very Negative

The economy is struggling, there’s no question about that.  However, 2.4% growth in 2002 is nothing to sneer at, especially considering the tragic events of 911.  We should be very proud that our economy rebounded so quickly!

But to hear most of the mainstream media characterize this economy, you would surely believe that we are in a recession now.  Everything is so negative.

We all know that the mainstream press has a liberal bias.  It has been that way as long as I can remember.  They don’t like President Bush, and they tend to “spin” the news to his detriment.  So, they continually  complain about the economy even though growth was firm last year (+2.4%), and we will soon see reports that it was positive for the 1Q as well.

Side Note: Great Media Bias Website

If you want to monitor the liberal bias in the media, there is an excellent website to visit.  It is called the Media Research Center CyberAlert.  This site is really cool!  For example, they monitor all the news anchors for the mainstream media (Rather, Brokaw, Jennings, etc.) and they point out all their liberal inferences and innuendo on a daily basis.  They cover and document many other instances of liberal bias as well.  You can subscribe for free, and they will e-mail you the same daily media bias reports that I get.  Check it out.  The web address to go to is www.mediaresearch.org.

The Media Has Turned Consumers Negative

Most Americans get their news from the mainstream media.  Given how negative the media has been, especially since George W. took office, it is no wonder that consumer confidence has plunged in recent months.  People think things are worse than they are.

As this newsletter is written, the media is doing its best to criticize the war effort.  For the last week, they have continually emphasized that the war is going to last longer than expected.  Longer than who expected?     They trot out “expert” after expert to second-guess the  war plan and in some cases, criticize the Bush administration.  For this reason, we should expect consumer confidence to remain low until the war is won.

Confidence Should Rebound Quickly

While consumer confidence is quite low today, that should change quickly and significantly when the war is won, or even sooner.  The latest polls show that 75% of Americans support the war, and President Bush’s approval ratings are back above 70%.   This tells us that most Americans are not buying the media spin that the war is going badly.  Therefore, I continue to expect a big boost in consumer confidence when the war is over, or whenever it is believed that Saddam and his regime have been ousted.  As consumer confidence rebounds, so will the economy.

This rebound in confidence could be underway by the time you read this newsletter.  While it looks today like the war will last at least several more weeks, we also are told that we have troops only a few miles outside Baghdad.  Obviously, there is no way for me to know when the war will end, but when it does, I believe consumer confidence will increase, and the economy will begin to strengthen.

As noted on page 1, the latest WSJ survey of 55 leading economists suggests the economy will grow by 2% in the first half of the year and 3.5% in the second half.  Unlike the negative media, these economists tend to err on the positive side.  But even if the economy only grows by 2-2.5% this year, that will still be quite an accomplishment in the wake of 911, in the wake of soaring oil prices and in the wake of the war.

Another Rate Cut By The Fed

The Fed left short-term rates unchanged at its March FOMC meeting.  The Fed indicated it had a “neutral bias” on rates going forward, but they emphasized the neutral bias was mainly due to the uncertainties about the war.  However, in light of the latest weak economic reports, there is growing optimism that the Fed will cut rates again at its May 6 FOMCmeeting.  In fact, BCA believes the Fed will cut short-term rates by another 50 basis points at the May meeting.  In just the last few days, several Fed officials have hinted at another rate cut in May.  This is another possible positive development that could help consumer confidence.

What Could Go Wrong?

As you know, I have suggested a continued mild recovery in the economy and a rebound in stocks for several months now.  I believe that is the “most likely scenario” after the war, assuming the war goes well.  But I also know there are plenty of things that could render that outlook wrong.  Let’s review those.

Another Terrorist Attack.  Clearly, another serious terrorist attack in the US would be a shock to the economy and could easily throw us into recession.  The good news is that the US is much safer today than it was on 911.  It will be harder for terrorists to carry out a major strike.  On the other hand, some tell us that al Qaeda has enjoyed increased recruitment, and there may be more terrorists planning to hit us.

The War Goes Badly.  Despite media bias, the war appears to be going very well.  The coalition controls apprx. 70% of Iraq as this is written.  Still, the most dangerous fight - Baghdad - is yet to occur.  While I would be very surprised, we cannot rule out the possibility that the war could turn ugly.  That would be bad for consumer confidence and the economy.

Consumer Debt.  We continually hear that consumers are about to stop spending because debt is at record levels.  Yet as I have discussed several times in the last year, apprx. 70% of consumer debt is in home mortgages.  Given the significant increase in home prices in recent years, most of this debt is very well secured and unlikely to default.

Home/Real Estate Prices Plunge.   The gloom-and-doom crowd has predicted for years that home/real estate prices were going to implode.  The fact is, these prices go up and down, but mostly up.  While prices could ease lower for a brief period, especially if the economy slows down more than expected, the age demographics support a continued rise in home/real estate prices for at least another 5-10 years.

Financial Surprise.  There is always the threat that Japan could fall off a cliff which could trigger an international financial crisis.  Although not likely, there is always the chance that some major US-based banks get into trouble (Japan, derivatives trading, hedge fund blowups, etc.).  This risk is always with us.

There are always risks and potential roadblocks to any economic forecast.  In the current environment, the risks may be higher than usual due to the war in Iraq and the continued threat of terrorist attacks.  Yet the war has gone very well in the first two weeks, and there have been no new terrorist attacks in the US.  Assuming the war gets wrapped-up in the weeks ahead,  and none of the other surprises discussed just above occur, the economy should begin to improve.

BCA’s Latest Thinking

In their April issue, the BCA editors maintain their positive outlook for the economy, and for the stock markets.  “Our base case is for a positive outcome [in the war], and a subsequent gradual improvement in the economy and thus earnings... The [Fed] policy environment will become even more stimulative as a result of recent events, and the basic fabric of the economy remains sound.”

While BCA’s best-case scenario is still positive, the editors did voice concerns about why the economy isn’t doing better than it is.  In their March issue, they concluded that consumer confidence was falling largely because the media is so negative.  Their latest April issue made no mention of this, and my read on their comments is that they are wondering if there isn’t something more substantive - that they may not be seeing - which is driving confidence lower.

They covered all the bases, including several of the risk factors Icited above, but concluded that the most likely scenario is still a pickup in the economy.  Nevertheless, Ican tell that they are becoming concerned that the economy isn’t performing better already.  If consumer confidence doesn’t rebound significantly after the war ends, I would not be surprised if their outlook turns more cautious or outright negative.  We’ll see. 

The editors continue to believe that stock prices will rebound once the war is won, but they stopped short of recommending “above-average” holdings of equities.  For now, they continue to advise “average” holdings of equities.  They say:

“The conditions for a cyclical rally in stocks are falling into place. The liquidity environment is favorable and pessimism is at an extreme. Nevertheless, the market will not make headway until the geopolitical picture improves...  Achieving decent returns will depend on successful market timing and good sector and stock selection.

From a long-term perspective, we expect the U.S. equity market to be in a broad trading range. This means that it will be important to catch the shorter-term swings in order to generate decent returns. This will mean buying when there is widespread pessimism, as exists today. The conditions for a rally are falling into place, and our bias is to be positive toward the market from a cyclical standpoint.”

The editors believe that Treasuries are vulnerable to an increase in yields, especially when the war is over, and longer-term as the economy improves.  They continue to recommend corporate bonds over Treasuries.

The editors believe that the bear market in the US dollar will continue for some time, although they expect the dollar to benefit from war/geopolitical concerns in the near-term.

Conclusions

The economy should begin to improve soon, especially if the war ends successfully and relatively soon.  That is the best-case scenario.  However, there are numerous potential negative surprises that could occur.  Expect the Fed to cut interest rates at least one more time, probably at the May 6 meeting.  Stocks should begin to trend higher, most likely when it is clear we have the war completely in our control.  However, it will be important to see that the market indexes do not fall below the recent lows around 7500 in the Dow and 780 in the S&P.  Should that occur,  it will signal that the bear market has farther to go.

The Yearn For Return

With CD and money market rates so low, and with stocks in the doldrums, many investors are asking where they can invest their money to obtain a meaningful return without undue risk.  You may have been inundated with direct-mail and telemarketers recently selling “sure bet” investments that can prosper during this time of uncertainty.  I’m sure our readers are smart enough to pass these investments up, but the question still lingers: Where can I invest my money today?

One bright spot on the investment horizon has been High-Yield Bonds (“HYBs”), also known as “junk bonds.”  This month, I’ll discuss the pros and cons of HYBs and how they can fit into a diversified portfolio.  As with most other investments, there is a good way to invest in HYBs, and there are several very bad ways.

The Basics

HYBs are issued by organizations that do not qualify for “investment grade” (BBB- or better) ratings by one of the leading credit rating agencies.  True to their name, HYBs generally offer greater yields to compensate for a significant increase in credit risk.  Clearly, companies that can’t qualify to issue investment grade bonds have a higher risk of default than those that can sell higher grade bonds.  Here are some recent average yield quotes on various classes of bonds.

The yield spreads among the various grades of bonds are significant.  The higher the perceived risk of holding the bonds, the higher the yield.  Today, the spread between HYBs and Treasuries is at a historically high level. 

Special Risks With HYBs

HYBs have the same risks as any other bonds -  interest rate risk, economic risk, credit risk - plus others.  When you buy investment grade corporate bonds, you generally don't worry about the company defaulting or going bankrupt, although it can happen.  But with HYBs, there is not only the higher risk of default, but there is also a higher incidence of “downgrading.”  The company’s credit rating may be downgraded while you own its bonds, and this almost always leads to a decline in the value of those bonds.

Another risk that is typically not an issue with investment grade bonds is liquidity risk.  Liquidity risk refers to the investor’s ability to sell a bond quickly and at an efficient price, as reflected in the bid-ask spread. High-yield bonds can sometimes be less liquid than investment-grade bonds, depending on the issuer and the market conditions at any given time.

The return spread between HYBs and Treasuries takes into consideration these different kinds of risk.  According to a recent analysis from T.D. Waterhouse, the historical total spread between Treasuries and HYBs is 4.5% to 5.5%.  Default risk makes up about 45% of this differential, and liquidity risk makes up the remaining 55% of the spread.

A “Hybrid” Investment?

We are now in the third year of a bear market and coming out of a recession.  As discussed earlier, assuming all goes well in the war with Iraq, most economists are predicting that the economy will continue to get better.  As the economy recovers, there is an increased possibility that interest rates will also rise.

The conventional wisdom surrounding bonds is that you do not invest in bonds during periods of time when interest rates will rise.  This is based on the sound principle that the price of most bonds decrease if prevailing interest rates increase.   This inverse relationship between bond prices and yields is what drives most of the trading in the bond markets today.

HYBs, however, do not always conform to the conventional wisdom in an economy on the rebound.  Historically, HYBs have led the way out of recessions.  For example, HYBs posted a gain of over 70% in the three years following the 1990/91 recession.  

The reason is that HYBs are correlated to stocks as much as they are to bonds.  A recent study by Ibbotson Associates shows that the correlation between HYBs and the S&P 500 was 0.5 over a period of 22 years.  This means that HYBs tend to track the performance of stocks about half of the time.  The same Ibbotson study shows that HYBs also have a 0.5 correlation to the Lehman Aggregate Bond Index.  Even though HYBs produce stock-like returns in periods of recovery, historical volatility is far less than stocks.

Thus, as the economy begins to expand again, generally speaking, companies that issue HYBs are better able to service their debt from cash flow and the prices of these bonds rise accordingly.  Oftentimes, the credit rating of these companies goes up as well, and this can lead to even more appreciation in their bonds.

At this point you may ask what happens if the economy doesn’t continue to improve.  The outlook for HYBs continues to be good.  With the historically high spread between HYBs and Treasuries, yield-hungry investors are searching for assets with a higher return.  This bodes well for the price of HYBs as compared to lower-yield corporate issues.

How To Invest In HYBs

Now that I have established that HYBs may be a good place for part of your portfolio, it’s time to discuss just how to invest in this market.  Given the risks noted above, most people should not invest in individual issues of HYBs on their own.  There are bond dealers and brokers who specialize in HYBs, and they may be able to steer you in the right direction.  However, I would not recommend going this direction as it is difficult to find a dealer or a broker that is really an expert in this complicated market.

Even if you do find a broker who is experienced in this market, the most critical part of investing in HYBs is diversification.  With the higher risk of default, and the other risks noted above, investors need to be able to purchase numerous different issues of HYBs.  The best way to do that is to invest in a high yield bond mutual fund(s).  Most HYB funds invest in dozens, or even hundreds, of HYB issues.  Different companies, different credit ratings, different maturities, etc.  HYB funds have a professional manager, usually with a team of analysts, that researches the various companies with whom the fund invests.

Most investors are not skilled in analyzing corporate financial statements, even those from large Fortune 500 firms, much less those who issue HYBs and may be having financial problems.  Therefore, I would only recommend investing in HYBs through a mutual fund that specializes in them.  And you should be very selective in the fund(s) you choose (more on this later on).

The combination of wide diversification and thorough due diligence helps to reduce the default rate and the other risk factors noted above.  This is why I would only invest in HYBs through a mutual fund which has a diversified portfolio and a professional management team that specializes only in this area.

Selecting The Right Fund

According to our Morningstar database, there are over 130 mutual funds that are distinctly classified as specializing in high-yield bonds.  If you look into all of the various classes of shares on these funds, the number swells to almost 400 funds.  Selecting one fund from among this large number of contenders is a difficult task for most individual investors.

One way to approach the selection process is to utilize the information on the Morningstar website ( www.morningstar.com).  This website allows you to search for the best funds by using criteria that you establish.  Note, however, that the best fund is not always the one with the highest recent performance.  You have to perform additional due diligence to see if that fund has taken greater risks by loading up on the “junkiest” of junk bonds that pay higher interest.  These bonds also have a much higher risk of default, so the high returns may be short-lived.

Another way to access high-yield bonds is through the ProFutures Dynamic Allocation Program.  We developed this investment program to assist clients in allocating their assets among various asset classes to help achieve and maintain diversification.  One of the asset classes used for diversification is the high-yield bond asset class.  The lack of full correlation with either bonds or stocks makes the HYB asset class an important part of any diversified portfolio.

The Dynamic Allocation Program can be used to obtain an asset allocation recommendation for your entire portfolio, or can be used to fill in the “holes” within an existing portfolio that you maintain elsewhere.  Since many portfolios do not already contain a HYB exposure of any kind, it would be beneficial for you to contact one of our Investor Representatives about the Dynamic Allocation Program.

Enhanced Returns Through Market Timing

Even the best mutual funds encounter periods of time when their strategy does not pay off.  That’s why it is important to have diversification among many different asset classes.  As of the end of February 2003, the top ranked high-yield bond mutual fund based on its 10-year average total return was the PIMCO High-Yield Fund , with an average total return of approximately 7.7%.  This compares favorably to the Morningstar average for all HYBfunds of only 5.2%, but the road to this return was somewhat rocky.  The PIMCO fund suffered a worst-ever drawdown of over 11% during this 10-year period of time.

To soften the ups and downs of the HYB market, another way to invest in high-yield bonds is through Capital Management Group (CMG), a market timer that I have mentioned frequently since we first recommended them last year. 

Since the inception of its bond programs in January of 1992, CMG has produced average annualized returns of over 11% in its non-leveraged program, and almost 17% in its more aggressive leveraged program.  That’s 10 years of outstanding performance.

CMG manages high-yield bond mutual funds in such a way as to be in the market when conditions are favorable, and out of the market when risks increase.  In the time since we recommended CMG last year, we have seen them go in and out of the market several times.  This ability to jump out of the market when risks are high is a key to successful market timing, and CMG has proved to be adept at it.

One of the most impressive parts of CMG's program is its ability to control risk.  The non-leveraged  program has a worst-ever drawdown of only -3.28%, while the leveraged program drawdown is slightly higher at -7.34%.   Still, it is extremely rare to find a manager who can both provide superior performance and limited risk over a period of 10 years. (Past performance is not necessarily indicative of future results.)

Since the beginning of the bear market in 2000, many investors have stopped looking at long-term track records in favor of scrutinizing what has happened over the last three years.   CMG invites this scrutiny:

I know that many of you are afraid to commit money to any investment during this time of uncertainty in the world.  However, CMG has shown the ability to manage high-yield bond funds effectively, not only during the go-go days of the 90’s, but also during  the fierce bear market of the last three years. 

I believe high yield bonds deserve a place in most investors’ portfolio, especially now with rates so low.   CMG has averaged 11% returns over the last 10 years with a worst drawdown of only 3.3% (non-leveraged).  This beat the returns of high yield mutual funds, and with less volatility.  That’s simply outstanding!

I encourage you to check out this very impressive program.  Just call one of our Investor Representatives at 800-348-3601 to obtain an Investor Kit that will provide much more information about CMG and this impressive program.

Read My Newsletter As Soon As I Write It

By the time you receive Forecasts & Trends  in your mailbox, the information is at least a week old.  In today’s fast moving world, things are changing so fast that the information in the newsletter could be obsolete by the time you receive it.  This is particularly true with our nation at war, with developments changing on a daily or hourly basis.  In some ways, this time delay affects what I can write in the newsletters.

I normally write F&T in the first few days of each month.  When I am finished, we send it to our printer electronically the same day.  Because of the size of our mailing list, it is 3-4 days before the printed newsletters are delivered to our office.  Then it takes us a day to insert them into envelopes, apply postage and get them in the mail.  By the time you get it, the information is at a week old, or even longer if a weekend falls in between.

I have had the same problem with the written research publications Irely on.  For example, for years I have paid FedEx fees every month to have The Bank Credit Analyst (and others) overnighted to me.  And even then, the information is several days old by the time it comes off the printing press and goes into the FedEx envelope.

E-Mail Has Changed Everything

Today I have almost all time-sensitive material sent to me by e-mail.   Even other newsletters I read that aren’t as time-sensitive I have sent to me by e-mail if they have that capability.  That way, I get the information either the same day it was written or the day after.  It’s wonderful!  Plus, if I want to quote any of that information to you, all Ihave to do is “cut-and-paste” it right into my article to you.   E-mail is the best way to get timely information in my opinion.

Let Me E-Mail Forecasts & Trends To You

If you have e-mail, I can get F&T and our other publications to you the SAME DAY I finish writing them or the next day at the latest, depending on what time of day (or night) I finish my writing.  If you use  e-mail, I think you will love this.

On the day (or day after) I finish writing, we would send you an e-mail that will include a “link” to the newsletter(s).  All you do is click on the link and up pops the newsletter, complete with any charts, graphs, etc.  You can either read it on your screen or print it out.  It’s that easy.

Enclosed is a reply card.  Please check the box that says you’d like to receive the newsletters at least a week earlier by e-mail.  Write in your e-mail address and send it back in the postage-paid return envelope. 

Weekly Forecasts & Trends E-Letters

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