To the surprise of virtually everyone, the Commerce Department revised its estimate of 4Q Gross Domestic Product from an increase of +0.2% to +1.4% (annual rate)!  As a result, economists are now revising their forecasts upward.  As noted inside, many now expect the economy to grow by 2½-3½% this year.

There was plenty of other good economic news in February, and the few bad reports were only slightly negative (details inside).  The economy is on the rebound, as The Bank Credit Analyst (BCA) has predicted, and we should remain in positive territory unless there are new negative surprises such as more terrorist attacks.

Fed chairman, Alan Greenspan, testified that he believes the economy has turned the corner and a mild recovery lies ahead.  With consumer price inflation very low and wholesale prices in an actual decline, Greenspan indicated the Fed will not have to raise interest rates anytime soon.

The stock markets rebounded strongly in late February/early March on the good economic news and Greenspan's assurances on interest rates.  Cash is starting to flow out of money market funds back into equities, and this trend should continue.  Despite what you read elsewhere, The Bank Credit Analyst believes corporate earnings are set to rise during the balance of this year, although not dramatically.  Thus, they believe the equity markets will continue to move higher but with continued high volatility.

Obviously, the equity markets have some new risks that could abort the renewed uptrend: more terrorist attacks; the potential war on Iraq; a possible financial implosion in Japan; and others.  The fact that these threats do exist argues for a market timing strategy which could get you out if these threats throw the equity markets into a temporary tailspin.

Gold has been a hot topic of debate in recent weeks as the price climbed above $300/oz. for yet another time.  As long-time clients know, I am no gold bull.  Yet some interesting things are happening which might well turn me into a gold bug soon.  Details inside.

Introduction

Editor's Note:  This month we have close to a thousand new folks who are reading Forecasts & Trends for the first time, thanks to an endorsement from my old friend and former business partner, John Mauldin and another from Bill Bonner who writes the Daily Reckoning.  This note is for our new readers.

Many years ago I came to the realization that I was not an economic or market guru, much to my ego's dismay, and that there were/are others in the forecasting field that are much better than I.  Since that time in 1985, I have tried to bring my clients the best information from successful outside sources on the economic outlook, the monetary environment and the major investment markets in these pages.

I subscribe to some very exclusive research and analysis services that are too expensive for most individual investors, and I bring you their best thinking and forecasts in these pages throughout each year.

My single best source for information on the economy and the major investment markets has been The Bank Credit Analyst (BCA), a Canadian research firm that has been making such forecasts successfully since 1949.  This research service is very expensive ($895/year for the basic monthly report, plus a lot more for their other more frequent reports).

Yet the cost has been more than worth it due to their prescient calls on major economic turns, interest rate turns and stock, bond and gold market turns.  BCA has been the single most accurate forecaster I have read in the last 25 years.  They have not missed a single major economic turn over that period, and they have been amazingly accurate on the long-term trends in the investment markets over that period as well.

While BCA is the most often quoted source in these pages, I also cite other advocates from time to time, not to mention my own views.  And we do not limit our coverage to simply investments. In this newsletter, we address a variety of issues ranging from politics (from a conservative viewpoint, of course) to geopolitics, international events and other developments that can, and often do, affect the investment markets.  As I said shortly after September 11th, "the world has changed forever." It has and our approach to investing has as well.

To new subscribers, just read on, have fun with us and make some cautious decisions for your investment portfolio.  We welcome your comments or suggestions.  Now, let's dive into the latest economic outlook.

More Good News In February

As noted on page 1, the Commerce Department increased its estimate of 4Q GDP from +0.2% earlier to +1.4% on March 1st.  This was surprising as most analysts expected the government would revise the GDP estimate to a negative number.

Many analysts continue to question the validity of the government's latest GDP report and believe the economy is still in a recession.  They point to the record large auto sales in November and December when car makers were offering 0% financing.  No doubt this played a role in GDP being positive in the 4Q.

Many of the same analysts also pointed out that the increase in 4Q GDP was due to "seasonal adjusting" which can sometimes turn an otherwise negative report into a positive one.  While it is true that this does happen from time to time, there was simply too much good news in November and December for me to  expect the government to take the latest +1.4% figure into negative territory in the final report later this month.  One example is the trade deficit, not seasonally adjusted,  which shrank by 11.6% in December and contributed to the stronger GDP number.

If the 4Q number remains in positive territory in the final report, that will mean we avoided the widely-held definition of a recession: two consecutive negative quarters in GDP.

Other Reports In February

The Index of Leading Economic Indicators (LEI) rose 0.6% in January, marking the fourth consecutive monthly advance.  This is a very solid indication that the economy is on the rebound.  Durable goods orders increased 2.6% in January for the second straight month.  Believe it or not, orders for high tech durable goods have risen for four consecutive months.

The housing sector continued on a roll in January (latest data available).  Housing starts rose 6.3% in January, the fastest pace in two years.  Sales of new and existing homes also remained hot in January.  Existing home sales hit a new record and are on pace to reach 6.04 million units this year.  The median sales price of existing homes rose in January to $191,500, up 8.9% over year-ago levels.  Business inventories continued to fall and are now apprx. 6% below year-ago levels.

The manufacturing sector rebounded in January and February after a year-and-a-half slump.  The Purchasing Managers Index has now risen 37% since its low last year.

Inflation remains no problem, at least for now.  After declining slightly in October-December, the CPI inched higher (+0.2%) in January.  Inflation is hovering around zero, at least as measured by the government.  Wholesale prices (PPI) actually declined by 2.6% in the 12 months ended January.

There were other positive reports in February, but let's shift to the negative news.  Consumer confidence slipped very slightly in January.  Retail sales dipped 0.2% in January as well.  Industrial production fell 0.1%, the smallest decline in six months.  Each of these reports was only modestly negative and are decidedly overpowered by the good news above.

Economists Scramble To Change Forecasts

With the surprising GDP report, most economists are now revising their forecasts for the balance of the year.  I am actually quite surprised to see how optimistic many have become.  Last week, we saw many of the big brokerage firms and banks - including Salomon Smith Barney, Lehman Brothers, JP Morgan Chase, Morgan Stanley and Wells Fargo - raise their estimates from little or no growth to +2.5-3.5% GDP for this year!  Others are following suit.

The Wall Street Journal declared the following:

"The economy appears to be coming out of recession at a faster pace than expected.  The latest evidence came in reports on manufacturing, which surged last month after a year and a half of shrinking, and consumer spending which rose briskly in January. 

The U.S. economy appears to be steaming out of recession, confounding broad-based expectations of a languid recovery and benefitting from a new flexibility woven into its fabric over the last decade."

It comes as no surprise that the big Wall Street brokerage and investment firms would quickly raise their forecasts based on the latest good information.  They are always optimistic.  I am surprised, however, that the senior economists at the big banks are also following suit.  Just a few months ago, people would have considered them crazy if they predicted the economy would grow by 3-3.5% this year!

Are They Too Optimistic?

Probably so. I believe economists, and most Americans for that matter, are turning more positive than expected, and sooner than expected, somewhat as a matter of pride.  Proud that the US economy is coming back so quickly after the trauma of September 11th and the devastating effects it had on many industries and the markets.  As a result, some of the forecasts we are seeing will probably be too optimistic by year-end.

On the other hand, since consumer spending accounts for over two-thirds of the economy, it is possible that the public could get so confident as to cause the economy to reach those forecasts.  I don't expect it, especially given consumer debt levels, but I would not categorically rule it out.  Remember, The Bank Credit Analyst suggested that if there was to be a surprise in the economy, it would likely be that the economy outperformed expectations.  Speaking of BCA, let's take a look at their latest report.

No Big Changes In February Report

BCA's 43-page March report was definitely more optimistic than the February report, but not as optimistic as the economists noted on the previous page.  Here are their conclusions:

"The economy is on a recovery path and, barring some unexpected shock, we doubt that it will be derailed.  It seems likely to be a subdued recovery, but it is always worth remembering that the U.S. economy has a tendency to surprise on the upside.  The fact that the downturn was so mild in the face of the bursting of the tech bubble and then September 11, is a testimony to the underlying resilience of the economy.

Even if the economy exceeds expectations, inflation should remain well behaved given the large amount of slack in the goods market.  This means that the Fed will not have to tighten the monetary screws any time soon, although rates will certainly be higher by year end.

In a normal cycle, equity prices would currently be rising, but the market is being held back by the combination of high valuations and fears about earnings.  The valuation problem will not go away quickly, but earnings concerns should diminish.  That should be sufficient to allow a cyclical rally to take hold within the next few months.  The trigger for a move to above-average positions will be when the major indexes break decisively above their 200-day moving averages.  High valuations won't prevent a rally, but raise a question mark over its sustainability.

We expect Treasury yields to drift higher as the economic recovery gains a stronger hold.  A positive inflation backdrop will limit the move, but the key point is that Treasuries are likely to underperform stocks over the course of the year.  This means that below-average positions in bonds are warranted.  Fixed-income portfolios should continue to emphasize corporate bonds over Treasuries because the current high level of spreads will narrow as concerns about corporate health diminish.

The bull market in the U.S. dollar remains intact.  The U.S. economy is leading the global economic upturn and this should benefit the currency. The dollar is likely to decline on a multi-year view, but the near-term picture is positive given ongoing problems in Japan and a lagging European economy."

BCA does include a list of possible problems which could occur that would render their forecast inaccurate.  First, they note that "Enronitis" could lead to a credit crunch.  Companies that have any hint of earnings shenanigans are being forced out of the credit markets, such as corporate paper.  These companies are thus forced to seek bank lending, and bankers are not willing to lend either.  If Enron-like problems are widespread, it could lead to a credit crunch which could drive down the stock markets.  Fortunately, BCA does not believe there are a lot more Enrons out there.

Second, they discuss the issue of the enormous derivatives position held by J.P. Morgan Chase.  Morgan and Chase have long been the two biggest players in the derivatives market.  Now that they have merged, they account for apprx. 60% of all outstanding derivatives.  Morgan Chase has more derivative exposure than the next 20 largest players combined, including Bank of America, Citibank and First Union National.  While BCA does not suggest there is any immediate threat to the financial system, they do warn that Morgan Chase can't make any major mistakes.

Third, the editors once again discuss the problem of consumer debt.  But unlike the gloom-and-doom crowd, BCA does not believe that high levels of consumer debt will choke the economy.  Instead, they believe consumer debt levels will merely be a drag on the economy, which will likely prevent growth from returning to 3-3.5% as some now predict. 

"In contrast to widespread fears, the consumer sector is not at the edge of financial disaster.  Debt burdens have increased, but there is not much evidence of major financial stress.  Most households have low exposure to the stock market and the fact that home prices are rising has been more important."

Most Americans Are Unaware

The BCA editors revisited their concerns about Japan's troubled economy and financial system. I wrote the following article for my SPECIAL UPDATE #17 which was e-mailed to clients on February 15th.

We hear bad news about Japan all the time, but most Americans have no clue how serious this has become.  Japan's economy, the second largest in the world, has been in a recession for the last 10 years.  The once invincible Japanese stock market has been in a monster bear market for over a decade.  What follows may not seem that interesting or important, but you need to get up to speed on Japan's worsening problems.

Japan is now at the edge of the cliff, and a financial and economic COLLAPSE is now very possible.  Here is a quick history of the Japanese quagmire from Stratfor.com in case you are not up on this issue:

"The Japanese economy has been mismanaged for more than a generation. The government historically sanctioned near-free loans to Japanese industry to allow massive expansion regardless of profit. Ultra-low interest rates prevented banks from making money from lending, their traditional revenue stream, so they purchased stocks and used the dividends to support their profit margins.

Companies in turn used their property as collateral to back up additional loans. Property values surged because expansion was seen as a priority, allowing Japanese firms to leverage their extremely expensive land holdings into yet more loans and more expansion.

The economic equation changed in 1990 when the Japanese property bubble burst. Companies [that were] holding suddenly depreciated [real estate] collateral had to borrow even more simply to keep level. Banks, spooked by the rapid deterioration of their stock portfolios, began making loans to firms they knew should be going belly up -- firms in which the banks often held stock. To prevent a meltdown, the government stepped in with more cheap credit, ultimately reducing interest rates to zero.

But by this point, consumers, whose spending makes up 55 percent of Japan's economy, were spooked too. As Japanese spending began to contract, firms found themselves with less and less income to use to finance their own operations. In textbook fashion, firms invested less, expansion slowed and deflation set in.

In what became an increasingly desperate attempt to shore up domestic growth, the government began a campaign of stimulus spending, first drawn from the budget surpluses that so impressed Americans in the late 1980s.

But Japan was a highly developed economy when the process of stimulus spending began. The network of roads, bridges and dams the government built were redundant and wasteful. What the spending did do was empower the construction companies.

As they gorged on federal cash, they hired swathes of Japanese workers, ultimately employing one-tenth of the entire non-agriculture work force. The construction firms, long the ruling party bedrock, became a politically powerful albatross from which the government would never free itself.

Prime ministers came and went, but rhetoric aside, all followed the same broad policies for fear of rocking the boat: cheap money and no reform, leading the country to where it stands now: in irreversible decline."      

On February 10th, Japan's finance minister announced a new economic and monetary plan which was heralded as the panacea.  Unfortunately, a closer look at the plan reveals it is just more of the same old approach.  It is now believed that the other G-7 nations have quietly decided to let Japan go over the cliff.  Here is Stratfor's latest analysis:

"The global recession induced by Sept. 11 accelerated Japan's already chronic decline. The most glaring symptom of the country's economic degradation is deflation. Low consumer and business confidence, a pain-averse populace and a reform-shy government have combined to stall economic activity.

Consumer prices fell 0.7 percent in 2001, the fastest decline in 30 years. Japan's consumer price index is now mimicking the longer-term decline in wholesale prices, which plunged 1.4 percent last year and an additional 0.2 percent in January, the 16th-straight monthly decline.

That deflation is now feeding into all sectors of the economy. Bank lending dropped 4.6 percent in 2001, the fourth yearly decline, as businesses cut investment. The long-term investment drought has been a major factor behind Japan's 5.1 percent export drop last year, which occurred despite a government-engineered 16 percent drop in the yen.

Unemployment has spiked up to a record 5.6 percent, a number that in itself is a gross underestimation since Japanese firms prefer to cut hours, not workers. High unemployment has helped push household spending down 1.8 percent for the year, which in turn feeds back into the low investment numbers.

The fact is that the government, despite printing currency like mad, no longer has the cash to rescue itself. The economy shrank every month in 2001, leaving the government with fewer resources to tap. The situation is so dire that Shiokawa has floated the idea of revoking the raft of tax cuts and exemptions granted citizens and firms over the past 10 years, in failed attempts to stimulate growth, [and] balance the books.

Assuming the incredibly unlikely event that Japan doesn't engage in any more deficit spending, by March 2003 Japan's federal debt will reach 140 percent of GDP, approximately $5.6 trillion. Debt servicing alone consumes 35 percent of all budgetary outlays.

The longer-term outlook for government revenues is even bleaker. The government anticipates that Japan -- saddled with one of the world's oldest populations -- will have a negative population growth rate by 2007. The country has already entered an era of declining revenues and increased pension costs as its baby boomers retire.

A new twist is that the Japanese people themselves are now second-guessing the government. The price of gold, the favored investment of those fearing downward volatility, was at a two-year high this week. Meanwhile, Japan's bad-loan problem continues to grow: its 17 largest banks registered a 13 percent increase in bad loans from last Sept. 30 to the beginning of Jan. 2002.

The daunting question for the G-7 is how do you salvage an economy so large, so dysfunctional and so integrated into the international system? While recommendations in the past have suggested tackling the country's mountain of bad loans, stimulating consumption or avoiding debt, at no point has the G-7 registered what is likely the final, morbid conclusion: Japan can't be saved."

The point is, if Japan's long recession worsens into a depression later this year, it could have negative implications around the world.  Maybe it won't happen, but Stratfor and BCA believe Japan is now closer to a full-blown collapse and depression than at any time since its economy went into this long downward spiral.

Japan is reported to own $333 billion in US Treasuries.   Japanese banks reportedly have apprx. $340 billion in loans to US interests.  There is a great deal of concern that Japan may have to cash in Treasuries and call in loans if conditions worsen, although I could make a case for why Japan would not want to do that - especially if the yen continues to tank.  Obviously, this is a very important situation that needs to be watched.

Since Stratfor and BCA wrote their latest analyses, there has been at least a little good news from Japan.  The Nikkei has risen over 21% in the last month, although this may be due to government purchases of stocks and new restrictions on short selling.  Also, a  new report shows Japanese business inventories have fallen to the lowest levels since 1990.  As a result of these and a few other minor positive developments, The Wall Street Journal predicted last week that the Japanese economy may have hit bottom and could turn modestly higher later this year.  We'll see.  In any event, Japan bears watching closely.

Interesting Developments

Gold prices rallied above $300/oz. in February.  There was a brief flurry of excitement as there has been every other time gold topped $300 in the last 4-5 years.  The flurry subsided once again when gold fell back to $295.  As long-time readers know, I have not been bullish on gold in many years, not since late 1979 to be exact.  But that may be about to change.

There are some very interesting things developing in the gold market, most of which are too lengthy to go into this month, which I will write about at more length next month and in my SPECIAL UPDATES.

The one thing I can mention in this limited space is the increasing evidence that the central banks may be all but done with their heavy gold sales which have kept prices below $300 for the last several years.  If this is true, the "short squeeze" that gold proponents have predicted for years may finally come to pass sometime later this year.

Even BCA, which has been bearish on gold as long as I have, predicted that gold prices have seen their lows and will trend modestly higher over the next year.  Again, I will have more to say about gold next month and in my SPECIAL UPDATES.

Is Inflation Set To Rise?

Obviously, if inflation were to start trending higher, after almost a decade of decline, that would be a very positive development for gold.  Yet as reported on page 3, inflation is not a problem now.  In fact, some analysts warn of deflation.  But with the economy on the rebound, traditional indicators suggest that inflation will be higher later this year.

For example, the money supply as measured by M2 climbed 9.6% in the 12 months ended January.  The more representative measure, "MZM," which includes institutional money market funds soared 19.1% over the same period.

Most people gauge inflation by the Consumer Price Index.  Many analysts also focus on the "core" CPI which excludes food and energy prices which are very volatile.  But I have always had a problem with both measurements because they don't include everything we consumers spend money on.  Some economists agree, and they track what is called the "median CPI" which is broader and more inclusive.  The median CPI also weights the underlying components as a median, rather than a mean in the CPI.  The use of a median rather than a mean, these economists argue, gives a better picture of the trend in inflation.  If so, the chart below will probably grab your attention.

Source: Barron's, Bureau of Labor & the Fed.

The median CPI measure bottomed in early 2000 and has been climbing ever since.  It levelled off just below 4% in the last two months.  If inflation rises to 4% later this year, that will be big news!

Some of that news would be very good.  It would mean that the economy recovers faster than we currently expect.  It would mean there were no more major terrorist attacks that sent consumers into paralysis.  It would also be good for gold.

Of course, there would be bad news as well.  Bonds would get hammered as that market is expecting inflation of only 1-2% this year.  It would also mean that the Fed would be putting on the brakes in the form of interest rate hikes, which would not be good for the stock markets.

The folks who follow the median CPI are solidly convinced that inflation will be significantly higher by the end of this year.  Yet that is not what we hear in the media or from other economists who don't follow the median CPI.

Frankly, I don't know which side to believe, but I think it is reasonable to assume that inflation is near its low, if not there already.  Historically, inflation rises as the economy recovers, and as discussed in these pages, the economy is clearly on the rebound.

As for gold, any increase in inflation would be a positive development.  This is just one more reason why gold could finally see at least a modest bull market.  We will look at this more in future issues.

Dorset Financial Update

A lot of clients have inquired about Dorset Financial Services and its gold mutual fund timing system.  Dorset is off to a great start this year.  At the end of February, Dorset had gained just over 15% net for the year.  For the five years ended February, Dorset had an average annual return of 14.5% net of all fees and expenses.  Pretty impressive in a market that's gone essentially nowhere for the last five years!  (Past performance is not necessarily indicative of future results.)

While there are some developments that could send gold prices higher for an extended period, Dorset's founder, Bruno Giordano, says it doesn't really matter to them.  He says their system might make more money if gold turns into a bull market.  On the other hand, he is content to keep pulling profits out of a continued trading range, if that continues.

Dorset uses the Rydex Precious Metals Fund.  The minimum investment is normally $50,000, but ProFutures' clients can open accounts with a minimum investment of only $25,000. If you have not requested information on Dorset Financial Services, I suggest you call us today at 800-348-3601.

Niemann Capital Update

As a special deal for ProFutures' clients, Niemann temporarily lowered their minimum account size from $100,000 to only $50,000.  Unfortunately, that deal ended on March 1st, and we could not get them to extend it.  If you got your paperwork to us by March 1st, they will accept you at $50,000.  Now the minimum is $100,000.

E-Mail SPECIAL UPDATES Continue

I continue to write 2-3 e-mail Special Updates each month.  These Updates cover a wide range of issues including our latest thinking on the economy and the markets, plus there are lots of links to articles and sources where you can learn more, and read other views, about the topics discussed. To receive these Special Updates, just send us your e-mail address.

Also, just as a reminder, you can get our monthly newsletters at least a WEEK earlier by going to our website at www.profutures.com.  This newsletter was posted on our website on March 6th.

The OTHER Gary Halbert

Every so often I remind you that there is another Gary Halbert out there.  He is Gary C. Halbert.  I frequently get e-mails from people who think I am him.  I don't know him, and we are not related. 

He advertises himself as a "marketing guru" and an expert in numerous other areas.  I have no idea if he is legit or a scam artist (although there's some very, uh... "interesting"... stuff about him on the Internet).  All I know is, I wish I was as smart as he says he is!