The Commerce Department reported that GDP rose at an annual rate of 1.6% in the 1Q, about in-line with expectations.  That followed growth of 2.4% in 2002.  The Consumer Confidence Index leaped from 61.4 in March to 81 in April, the second largest gain on record.  Yet unemployment rose from 5.8% to 6% in April.  So, the economy is growing but it is a slow recovery.

The Bank Credit Analyst was surprisingly upbeat in their May report.  The editors believe the economic recovery is on sound footing and predict that GDP will rise by 3-4% (annual rate) in the second half of this year.  This, of course, assumes no major negative surprises.

Interestingly, BCA believes that deflation is no longer a major threat, and that we should begin to consider rising inflation.  If you read the “gloom-and-doom” crowd, you know that they are convinced we’re headed into a deflationary depression.  As usual, BCA does not agree.  I’ll give you the “Readers Digest” version in this issue.

Stocks are bumping up against overhead resistance as this letter is written.  It remains to be seen if they can break out this time.  BCA believes they will and that we could see stocks rally, generally speaking, for the next 6-12 months.   They are not predicting a powerful bull market, but they expect the rally will be worth participating in.

BCA also believes that bonds are due for a fall, especially Treasury bonds.  Bonds have been an increasingly popular place for investors to go over the last two years.  Historically, bonds have gone down when the economy recovers, and BCA believes this time will be no exception.

Given the scenario BCA expects, now should be a good time to increase allocations to equities.  Niemann Capital Management, Potomac Fund Management and Hallman &McQuinn have all held up well this year, despite the choppy equity markets.  Capital Management Group , our recommended bond timer, is up over 10% so far this year.  I suggest that you consider all these programs if you have not already.

Editor’s Note

Most of the following analysis on pages 2-4 is reprinted from my April 29 weekly E-Letter, and updated with more recent information beginning on page 4.  We still have over 1,000 clients who do not get the weekly E-Letters, so there will be times when I reprint that information in this newsletter.

Latest Economic News

As noted on page 1, the latest report on 1Q GDP showed a rise of 1.6% (annual rate).  Expectations had been in the 1.5-2% range, but the media made it sound like economists and market analysts were expecting a rise of 2-2.5%.  Not so.   And if the GDP report was so bad, as the media suggested, why were the stock markets UP STRONGLY the following day?

The truth is, the GDP report was just OK - not bad, but not that good either.  At least it was positive.  You can look at economic data with a negative bias, as the media and the gloom-and-doom crowd do, if you like.  You can also assume we’re headed back into a recession if you like.  I happen to have a different view.

I believe it is nothing short of amazing that the US economy grew by 2.4% in 2002, on the heels of the September 11 terrorist attacks that shocked our nation and the world, and in spite of the plunge in the stock markets! 

On another front, consumer confidence rose again in the last half of April.  The University of Michigan's Consumer Sentiment Index rose to 86, up from 83.2 at mid-April and 77.6 for March.  The Consumer Confidence Index leaped from 61.4 in March to 81 in April, the second largest gain on record. These are  very good indicators, even though consumer spending increased only 1.4% in the 1Q when people were worried about the war.

I continue to believe the economy will gradually improve during the course of the year, especially now that the war with Iraq is over.  I'm not alone in this view.  As noted on page 1, The Bank Credit Analyst was quite upbeat in their latest May research report.

BCA's Latest Thinking

Here are some excerpts from the May issue of The Bank Credit Analyst.

“The bearish view of the economic outlook has been fully embraced by a number of Wall Street’s leading commentators. It remains an easy story to tell: heavily indebted consumers will cut back on spending, companies will have no reason to expand for the foreseeable future, and the Federal Reserve is almost out of interest rate ammunition.  Meanwhile, many parts of the world are in even worse shape. Even Asia, the major bright spot in an otherwise bleak economic landscape, now faces the uncertain impact of the SARS epidemic.

Indeed, there is much to be concerned about in the economic outlook, but we are holding to our view that the gloom is overdone.

The corporate sector has been through a severe recession during the past couple of years, but that has now run its course.  Meanwhile, consumers are in reasonable financial shape, and spending is not set to collapse.

The U.S. economy has displayed remarkable resilience in the face of a series of severe shocks during the past few years, and the odds are good that growth will surprise on the upside in the second half of the year. The economy is not going to boom, but growth should be strong enough to calm fears of deflation and foster increased risk-taking on the part of investors.”

The BCA editors believe that three primary factors have led to the slowdown in economic growth during the 4Q and the 1Q:  1) war worries; 2) severe winter weather; and 3) high oil prices.  Of those three, the first two are gone, and oil prices are trending lower.

Consumer Debt Not A Huge Problem

The gloom-and-doom crowd would have you believe that consumers are tapped-out, and that spending is set to fall off a cliff.  They most often refer to the “debt-to-income ratio” which reached a new peak of 106% at the end of 2002.   However, the BCA editors point out, similar to what I have said in previous issues, that home mortgages now make up apprx. 80% of all consumer debt. 

When presented with the statistic above on home mortgage debt, the pessimists then argue that home prices are in a bubble that is bound to burst, at which point consumers will stop spending.   I addressed the outlook for home prices in the April 8 issue of my weekly E-Letter and concluded that home prices are not about to implode.  On this point, BCA says:  “The key risk to household balance sheets would be a sharp drop in house prices, but that is not in the cards.”

Regarding consumer debt levels, BCA says, “A decline in delinquency rates [on a percentage basis] in home mortgages and other consumer loans during the past year suggests that debt burdens are not putting any undue stress on consumers. Moreover, earnings reports from major banks indicate that loan quality continued to improve in the first quarter, despite a weak labor market."

Moreover, they say, “The ownership of both assets and debt is highly skewed toward the rich, and this means that aggregate data can give a misleading picture of the financial health of the typical consumer… The average consumer does not own much [in] equities so was not overly hurt by the stock market collapse and debt burdens have been manageable.”

The Outlook For Unemployment

The unemployment rate rose to 6% in April, up from 5.8% the two previous months.  This increase was widely expected, so it did not have the usual negative effects on the equity markets.  The pessimists argue that this number will only go higher.  As usual, BCA has a different take: “Labor market indicators have been weak recently, but we assume that this largely reflects the combination of temporary headwinds [war, weather and oil] noted above. With the war now over and corporate profits staging a modest recovery, there is no obvious reason why companies should embark on an accelerated pace of cost cutting [layoffs]. More likely, employment should gradually improve over the remainder of the year, helping real wages to grow by around 3%.

Even if the saving rate rises, real consumer spending growth should still comfortably exceed 2% in the coming year. That will be consistent with a decent pace of economic growth, assuming that there is also a modest recovery in business spending.”

What About Business Spending?

In its GDP report, the Commerce Department estimated that business spending decreased 4.2% in the 1Q after rising in the 4Q.  Here, too, BCA believes the 1Q decline was very likely the result of war worries, weather and oil prices.  The editors believe that business spending will improve, perhaps significantly, over the next year. 

One of the pessimists’ favorite arguments is that business spending is not going to increase because the factory operating rate (capacity utilization) is only at 72%.  BCA points out, however, that the capacity utilization rate refers only to the manufacturing sector, which accounts for less than 25% of private sector investment in equipment and software.  What this means is the capacity utilization rate is a narrow indicator of the economy, and only one of many indicators we need to watch.

Regarding the outlook for business spending, BCA has a different view.  They say:  “The bottom line is that the conditions are in place for a revival in business spending… There is also potential for increased company spending on inventories. The ratio of inventories to sales is at a secular low, and there is even a risk of shortages when demand picks up.  The missing ingredient is confidence: companies will not expand if they fear a downturn in the economy, and that clearly has been an issue in recent months. Hopefully, confidence will now show an improvement, encouraging companies to abandon their retrenchment mindset.”

Other Reasons To Be Positive

BCA believes that the monetary environment will remain very accommodative.  They believe the Fed will cut interest rates serveral more times if needed.  In addition, they believe the economy will benefit from increased government spending and whatever tax cuts the Bush administration may be able to wrestle out of Congress.  They also point to the falling dollar as another positive for the US economy. 

In conclusion, the BCA editors say, “The bottom line is that it is quite easy to generate a forecast of real GDP growth in a 3% to 4% range in the second half of the year.  All it requires would be real growth rates of 2% to 2½% in consumer spending, 5% to 10% in [business] investment, 5% in government spending, modest inventory building, and a reduced drag from trade. None of these are extreme forecasts. One has to make rather pessimistic assumptions to have growth below 3%, and this would probably require some new shock to confidence."

The Case Against Deflation

The gloom-and-doom crowd promises that we are headed for a deflationary recession/depression.  Even   BCA cautions that deflationary forces are still the prevailing undercurrent around the world.  They caution, for example, that if there are more major negative surprises (like another serious terrorist attack on US soil), the US could fall into a deflationary spiral.  But is that the most likely scenario?  Probably not.  Let’s look at what BCA had to say about deflation in their latest May issue.  It may surprise you, especially if you read some of the pessimists as I do.

“A return to 3% to 4% economic growth would go a long way to defuse current fears of deflation. The current environment is still deflationary in the sense that core inflation is low and falling, with many companies finding it difficult to raise prices. Nevertheless, the seeds of a return to inflation are being sown.

First and foremost, the Fed has made it abundantly clear that it will go to great lengths to make sure that the economy does not fall into a deflationary slump. Policymakers are very aware of the mistakes made in Japan and in the 1930s, when monetary policy was kept too tight.

[Fed] Governor Bernanke has been unusually explicit in implying that the central bank could run the printing presses 24 hours a day, if necessary, in order to flood the system with liquidity. That will not happen, but it is clear that the Fed is prepared to take extraordinary measures to support the economy.

We are currently in the following situation:
1. Monetary policy is very easy.
2. The budget deficit is soaring.
3. The dollar is falling.
4. Pipeline measures of inflation have moved higher.
5. Companies face increased costs for security and insurance, diverting resources from more productive spending.
6. Moreover, oil prices are substantially above earlier levels.

In normal circumstances these trends would be associated with sharply increased inflationary pressures. However, the fact that the economy is operating below capacity and weak conditions in much of the rest of the world mean that inflationary pressures are well contained for the moment. We should not assume that this will remain the case when growth picks up and the Fed is slow to push interest rates back to a more normal level.

Inflation could continue to drift lower in the near run in lagged response to earlier economic weakness. However, the Fed has been keeping the fed funds rate below the nominal GDP growth and Chart I-5 [not shown here] shows that inflation pressures often bubble up when this happens.

By year-end, deflationary concerns should be giving way to the realization that policy will need to be tightened in order to prevent inflation from reemerging as a problem. The bond market should anticipate this.

As an aside, the trend in Canadian, Australian and U.K. consumer prices should dispel the notion that inflation cannot exist in the current competitive environment.”

If BCA’s economic forecast of 3-4% growth in the second half of the year and on into 2004 is correct, they believe that it will overcome the global deflationary forces.  I think they are correct to assume that the Fed will be slow to raise interest rates, especially this year, and this would increase the likelihood that inflation could once again take hold.

Again, this flies in the face of most of the analysis out there as almost no one is currently thinking about inflation.  When BCA says, “The bond market should anticipate this,” what they really mean is that bonds will get hammered.  Bonds are priced today to reflect a deflationary global environment.  Treasury bonds in particular reflect not only the deflationary environment but also the “safety premium.”  If the economy is recovering nicely by the end of the year, and there have been no major terrorist attacks, bonds could fall significantly.

Investment Recommendations

Like many of us, BCA is not entirely sure if the long-term bear market in stocks is over or not.  However, the editors believe that conditions are right for at least a cyclical upturn in equities over the next 6-12 months.  They recommend average holdings of equities. 

FYI, BCA does not subscribe to the belief that P/E ratios have to bottom at 7-8.  They believe that the market reached fair valuation at the lows in October when the S&P 500 “Forward P/E” fell to near 14.  Their analysis of equities includes many indicators besides P/E ratios.  On a technical basis, they believe the next milestone is the 960 level in the S&P 500.  If the market can close above that heavy resistance level, I expect they will move from “average” to “above average” holdings of equities.

As noted above, the BCA editors continue to believe that bonds, especially Treasuries, are overvalued and subject to losses, particularly if the economy continues to recover.  As a result, they recommend corporate bonds over Treasuries.

We know that many investors have moved into Treasuries and bond mutual funds over the last couple of years, due to the decline in stocks.  Unfortunately, many believe they are “safe” in bonds and bond funds.  The fact is, bonds can be just as risky as stocks, or even more so.  This is why I continue to recommend that you look at Capital Management Group and their high-yield bond timing program.  They are already up over 10% so far this year.  They’ve averaged over 10% a year for the last 10 years.

Conclusions

BCA believes the economy will continue to recover, and that growth in the second half of the year could well be in the 3-4% range, absent any major negative surprises.  They believe that both consumer and business confidence will improve slowly now that the war is behind us.  And they believe that stocks could have a cyclical upturn that could last for 6-12 months.

I realize this forecast flies in the face of what you may read from the pessimists and the gloom-and-doom crowd who are (always) predicting deflation and recession.  And I must state for the record, there is no guarantee that BCA's latest forecast will prove to be accurate.  All I can say is that they have been more accurate (not perfect, mind you) than any other source I have followed over the last 25 years.

So what does this forecast portent for our investment portfolios?  Two things, to me at least.

1.  We should be IN the markets, both in stocks and bonds, and not sitting on the sidelines; &

2.  A good portion, if not most, of our investments should be in MARKETTIMING programs.

Consider Niemann, Potomac and Hallman &McQuinn for your equity investments.  All three are profitable this year.  All three have significantly outperformed the market over the last three years.  And by all means consider Capital Management Group and its bond timing program.  As noted above, CMG is up over 10% this year (unleveraged program).

Another Terrorist Attack?

BCA had only one caveat to its latest upbeat forecast - that there will be no major negative surprises.  Obviously, another serious terrorist attack in the US would be a major negative surprise that could throw the economy back into another recession and the equity markets into another tailspin.

Prior to the war with Iraq, many of President Bush’s critics warned that if we attacked Iraq, there would be more terrorist attacks in the US.  I disagreed with these assumptions in my weekly E-Letter at the time.  My argument was, and still is, that if terrorists had the capability to carry out another major attack in the US, they wouldn’t have waited for the US to attack Iraq.   The risk of being discovered is just too great for terrorists to wait.

It is true that there is no way to know if another serious terrorist attack will occur, but I don’t think investors should assume the worst.  In fact, I think there are reasons to be optimistic.  Clearly, we are safer today than we were before 911.  Our government intelligence agencies are now working more closely together than they were pre-911.  Law enforcement has been increased.  Our airports are clearly much safer today.  In addition, Americans are more aware of the threat, more aware of their surroundings and have provided valuable information to authorities.

Along this line, dozens of known terrorists have been rounded up, both in the US and abroad, including many top al Qaeda leaders.  Several planned terrorist attacks have been prevented.  And we continue to round up terrorists to this day.  So, while we can’t rule out another  terrorist attack in the US, I don’t think we should plan our investments on the assumption that there will be more serious attacks.

Middle East Is Stabilized

Our leaders from President Bush on down say that we will not be in Iraq permanently, that we will withdraw our forces “as soon as possible.”  As soon as possible, in this case, means YEARS.  With USforces in the heart of the region, the Middle East will be much more stable.  The likelihood of a major war in the region has been reduced.   This does not mean there will be no unrest in the region.  Hopefully, we will see internal revolts and regime change in countries like Iran, Saudi Arabia and Syria.  But I don’t expect to see a major, market-disrupting war in the region.

More Oil, Lower Prices

Our stunning success in the war on Iraq, along with our continued military presence in the region, should lead to significantly lower oil prices in the months ahead.  While it will take time to get Iraq up to full exporting capability, I predict it will happen sooner than most analysts expect.  After all, US companies are doing the rebuilding.

Market Implications

The US is clearly safer today than it was pre-911.  The world is a safer place with US troops stationed in the heart of the Middle East.  The odds of market-crashing events are lower today.  Yet the cash sitting idle in money market funds was a whopping $2.2 trillion as of the end of April.  Obviously, many investors are still sitting on the sidelines, partly due to concerns about the issues discussed on this page.  Yet as I have pointed out, these risks are lower today than at any time since 911.

Barron’s “Big Money” Poll

Twice a year, Barron’s polls around 150 professional money managers around the country.   In the latest poll, 60% said they were bullish now , versus only 43% who were optimistic last fall.  The poll was taken just as the US was rolling into Iraq, so they may be more optimistic now.  The average expectation is for the Dow to reach around 9300 by the end of the year.  On average, they expect the economy to grow 1.9% for 2003 and 2.7% for 2004.  The average allocation was 64% stocks, 23% bonds and 13% cash.

Democrats Hold First Debate

That’s right, believe it or not, we are now in an 18-month general election cycle.  This is simply too much, even for a political hack like me.  Naturally, we have the Democrats to thank for it.  Fearing that a well liked, scandal free, says-what-he-means, leader who is coming off of a huge military victory (and is unlikely to repeat the mistakes of his father) will be very difficult to unseat, the Democrats have already held their first debate in South Carolina.  I was not impressed!

If you don't already know, here are the Democrats who are running for President: Sen. Joe Lieberman, Sen. John Edwards, Sen. John Kerry, Gov. Howard Dean, Rep. Richard Gephardt, Rep. Dennis Kucinich, Rev. Al Sharpton, Carol Mosley Braun and the latest entry, Sen. Bob Graham of Florida.

For the most part, the candidates engaged in “me too” politics when asked about the President's handling of the war and national security.  When discussion turned to the economy, the issue the Democrats are desperate to take center stage, the contenders took turns beating up President Bush.  They also turns bashing the national health care plan of Dick Gephardt.  None of the hopefuls distinguished themselves, but neither did any of them self-destruct.

Edwards seemed young and a bit too cocky; Lieberman was plodding, dull and harmless. Kerry remained aloof and wooden, while the rest just melded together into one big forgetful mass.  It would have been nice to have seen some sparks fly; instead we were treated to stilted dialogue and monotone lecturing.  In the end, this very early, very staged event was as stiff as one of Al Gore’s undershirts.

If this first outing is any indication, this broad field of candidates will struggle to impress.  Left-leaning pollster John Zogby summed it up best saying, “I was singularly unimpressed. From the vantage point of the public, I doubt that any undecided viewer came away with anything new out of this…the only hope right now is that perhaps very few people were watching.”   Ouch!

It is important to understand that the DNC has completely “front-loaded” the primary schedule so that they can “anoint” and rally behind one of these contenders early-on, reducing the damage of a bruising nomination fight.  With their convention a full month before the GOP’s, the Democrats hope to set the tone for the national debate going into the “real” election cycle next year.  

In this kind of front-loaded scenario, the candidate with the most money has a massive advantage.  Using money as the yardstick, the current leaders are John Kerry and John Edwards.  National polls currently favor Sen. Lieberman above either of these men; however, no one comes close to a majority.  In contrast, if the election were today, President Bush would trounce any and all comers.

George W. Bush is a tough customer and getting tougher by the day.  If he lands on another aircraft carrier, the Democrats might as well pick up their toys and go home, or so it would seem.  Some are even whispering the “R-word,” that he is Reaganesque. Well, let’s not get carried away.  The election is 18 months away, and as Bush, Sr. learned, a LOT can change.

The Bush/Rove Strategy

Here is the Bush re-election strategy as we currently understand it.  Karl Rove, President Bush’s political guru, is now operating in full-blown general election mode.  He has a bold, some would say risky, re-election battle plan that has the GOP convention taking place a full month AFTER the Democratic convention. Why?

Allowing the Democrats to go first seems like a mistake.  It will allow them to control the debate and take the lead on the major issues of the campaign, right?  Well, not exactly.  The President will run completely unopposed in the primaries, winning every one. So, in effect, the general election cycle for the GOP has already started, and there will be no bloody intra-party scrapping.  The Rove strategy, as we understand it, is to minimize the money spent during the primaries (as there is no real need) and save that huge hoard of cash to attack the Democratic nominee as soon as he is crowned at the national convention in Boston.

Side Note.  Why in the world did the DNC decide on Boston to hold their presidential convention?  Why would anyone, short of a total moron, in the DNC not recognize that New York City, where the 911 attacks occurred, was THEPLACE to hold the 2004 Democratic convention?  But apparently the DNC caved to Ted Kennedy and agreed to hold their convention in Boston.  DUH!  Karl Rove and RNC Chair Marc Racicot immediately chose New York City for the GOP convention as soon as the DNC selected Boston.  Thanks, Ted! 

The Bush Onslaught

Just after the Democrats’ convention, and before their candidate gets matching Federal funds, Bush/Rove reportedly plan a massive media barrage , so we learned over the last two weeks of April.  The Bush campaign appears to be planning to pour in excess of $200 MILLION into the media markets over this period of time, attacking whoever is the Democrat nominee. That is likely more money than any Democrat candidate will have at his disposal for the entirety of the campaign.  I say likely more because one of the Democratic candidates, John Kerry, is fabulously wealthy (the husband of Patricia Heinz - heir to the Heinz Ketchup dynasty) and may be willing to dip deeply into his own pockets, if he actually gets the Dem nomination.

$200 million, by the way, is more than has been spent on any entire political campaign in history.   Bush is loaded with the largest war chest ever.  Imagine if he spends $200 million, just in the period right after the Democrats’ convention, the damage he could inflict on whoever is the Dem’s nominee.

Then, by holding the Republican convention on August 30 and on through the Labor Day week, Rove and Racicot may have outflanked the Democrats on several fronts.  The Democratic nominee could end up waiting weeks, if not months, for federal matching funds. What’s more, the move could give President Bush a much bigger media spotlight, sending him into the general election with a surge of political momentum, while the Democrats’ much earlier convention will have long since faded from memory.

At first blush, it appeared that Rove let the Dems get the best of him in terms of the presidential debates and conventions.  But as we have seen time after time since Bush took office, Rove is rarely outmaneuvered.  When you look at his reported plan, as outlined just above, it seems brilliant once again.

Of course, George W. seems invincible today.  Whether or not President Bush is Reaganesque, our plain-spoken Commander in Chief shines in comparison to a heavily lackluster Democratic offering.  But we all know that could change.  The election is a year and a half away.  Come November 2004, could Bush lose?  Sure, it’s possible. Currently though, the chances for that look mighty slim.

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