In this issue, I will focus on the latest outlook from The Bank Credit Analyst.  In short, BCA believes the economic recovery will continue for at least the next 12-18 months.  As discussed below, BCA believes the economy can improve to a 3% rate, or even better, in the second half and continue to improve modestly in 2004.  Yet while BCA is optimistic about the next 12-18 months or so, they have some dire warnings beyond that time, or whenever the next recession arrives.  In short, BCA believes the “Grand Supercycle” (long-term economic upwave) they predicted in 1991 will come to an ugly end whenever the next recession hits, perhaps in 2005 or 2006.  I will share this latest forecast with you in detail in the pages that follow.

The Commerce Department revised its estimate of 1Q GDP from 1.9% down to 1.4% (annual rate).  The economy is recovering slower than most economists expected, and unemployment jumped to 6.4% in June.  As discussed last month, unemployment will likely continue to edge higher until economic growth gets back up to 2½-3%.  BCA and others expect we will see growth reach that level in the second half of the year.

Stocks are still struggling to break out above overhead resistance.    BCA believes they will break out and that we could see stocks rally, generally speaking, for the next 6-12 months at least.  They continue to recommend market timing strategies.  All of our recommended market timing Advisors are up nicely this year, so you may want to consider adding to your equity holdings, especially if we get a further pullback just ahead.

Bond yields have been on the rise of late.  Traders want more assurance that the Fed is committed to keeping long rates low.  I believe they will get that assurance very soon. As I will discuss later, the Fed is very serious about stimulating the economy and keeping interest rates low. This may be an excellent time to consider Capital Management Group, our recommended bond timer, which continues to be on a roll this year.

Elsewhere, the US dollar should continue to move lower.  Gold is likely to continue to move higher as a result.  These and other trends could make the next year or so a good time for our futures funds.

Make Hay While The Sun Shines

In the June issue of BCA, the editors offer what I consider to be one of their most significant forecasts in the 25 years that I have been reading them.  If correct, this latest forecast will rank right up there with their 1979 forecast for the end of inflation (sell all tangibles), their 1981 forecast for an economic revival and a multi-year bull market in financial assets (stocks and bonds), and their 1991 forecast for a technology-led boom in the economy.

As suggested on page 1, BCA believes the next 12-18 months will be a generally good period for the economy and for equity prices.  Beyond next year, however, they do not know what to expect.  What they do believe is that whenever the next recession hits, we could well find ourselves in a financial crisis.  They believe we are approaching the end of the Grand Supercycle they predicted back in 1991.  I will analyze both their short-term forecast (12-18 months), and their longer-term warning (beyond 2004).

Before I do that, I believe it is critically important that you make the most of the next 12-18 months.  You need to be in the markets, in my opinion, especially if you use market timers.  The goal should be to maximize returns over the next 12-18 months during the economic recovery. 

You should also take the time to learn about futures funds, hedge funds, currency funds and other alternative investments that may have the potential to do well, even in a serious recession and/or financial crisis which could be coming in the next few years. 

I am working on a new Special Report on “Alternative Investments” that will be ready in the next few weeks.  It will discuss the various types of non-traditional, alternative funds and investments noted above.  The Report will be free of charge to clients.  I will also have sections of the Special Report in my weekly E-Letters later in July.  If you aren’t receiving my weekly E-Letters, you should be (if you have a computer).  Call us or go to www.profutures.com to sign up.

First, The Good News From BCA

BCA believes that the US economy will recover to a 3-4% annual growth rate in GDP by the end of the year.  BCA cites the Index of Leading Economic Indicators which has risen for the last four months, as well as other indicators.  BCA believes the economy will continue to recover due to four primary factors:

1.  Low rates & aggressive monetary policy;
2.  Record deficit spending in Washington;
3.  President Bush’s latest tax cuts; and
4.  The falling US dollar.

BCA believes these factors, and others, will ensure that the economy recovers for at least the next 12-18 months.  They say:

“Record policy reflation should ensure that economic growth moves to a 3% to 4% pace during the second half of the year and into 2004. The risks of a debilitating deflation are low.

Super-stimulative monetary policy will be the driving force behind market performance during the next 6 to 12 months. The Federal Reserve plans to keep short rates at close to current levels for an extended period and this should reward those investors who have taken on some portfolio risk.”  They continue:

“There continues to be a powerful tug of war between massive policy reflation and the lingering after-effects of the various shocks that have hit the economy during the past three years. The sharp drop in interest rates and tax cuts have been successful in sustaining consumer spending, but have not yet managed to trigger a rebound in business spending. Corporate executives remain extremely cautious, focused more on cost cutting and balance sheet restructuring than on expanding. Nevertheless, business confidence should gradually revive in the second half of the year, aided by a continued improvement in profits.

Deflationary concerns may persist for several more months, but the odds that the economy will fall into a Japanese-style slump are low. It is far more likely that economic growth will surprise on the upside in the next year as the latest tax cuts take effect and the manufacturing sector responds to the competitive   boost from a lower dollar.

Recent gains in the stock market suggest that investors are already discounting an improvement in economic activity and earnings. Nonetheless, the rally has further to go on a cyclical basis given that monetary conditions will stay extremely easy for an extended period. The Federal Reserve wants to encourage risk-taking and it will be worth playing its game for a while longer.

There is a tendency to assume that policy has been ineffective given the economy’s softness during the first half of 2003. Some have argued that if the economy is still growing sluggishly after all this monetary and fiscal stimulus, why should we expect any improvement in the months and quarters ahead? This argument could be turned on its head.

The U.S. economy has endured an extraordinary barrage of negative shocks in recent years, beginning with the bursting of one of the past century’s greatest asset bubbles. This was followed by the 9/11 terrorist attacks, a damaging spate of corporate scandals, two wars and a spike in energy prices.

Yet, the economy suffered its mildest recession on record in 2000/2001. The economy’s performance in the face of so many adverse events reflects the effects of powerful monetary and fiscal stimulus as well as the economy’s underlying resilience.

It is true that the mild nature of the downturn means that there has not been the pent-up demand for consumer durables and housing that typically occurs in a recession. That is why there will not be vigorous growth in these areas in the coming year. However, business spending did suffer a vicious cutback and there is pent-up demand in this area. The building blocks for increased spending are in place: inventories are low, net investment (capital spending minus depreciation) as a share of GDP is as weak as it has been in the post-WWII period, and profits are recovering. Business confidence is still depressed, but the small business survey carried out by the National Federation of Independent Business suggests that sentiment may have bottomed.

We expect that economic growth will move to an above-trend pace during the second half of the year and the momentum should carry into 2004. The Conference Board’s leading economic indicator has moved back above the boom/bust line, implying that the economy’s soft spot has run its course.

Deflation concerns should be much diminished by the end of the year in response to stronger economic growth. The annual inflation rate may dip below 1%, but a slide into a destructive deflation is not in the cards. The Fed has made it clear that it will go to extraordinary lengths to make sure that deflation is averted.”

BCA’s analysis gets much more technical, but you get the drift.  They believe the Fed will win, that business spending will increase, that the economy will move back to a 3-4% growth rate over the next six months, and that the recovery will continue in 2004.

They recommend slightly above-average holdings of equities.  BCA continues to favor “market timing” strategies over a buy-and-hold approach. They also recommend slightly below-average holdings of bonds.      They believe investors should be reducing exposure to Treasuries and increasing exposure to corporate bonds, high-yield bonds in particular.  In addition, they are still bearish on the US dollar and bullish on gold.

If BCA’s outlook is correct, the next year or year and a half should offer some very good opportunities.  In my view, this environment should be very good for the market timers we recommend.  If you have money sitting on the sidelines, maybe now is the time to get back into the market.

BCA concludes: “There are reasons to be concerned about the longer-run outlook in terms of rising financial imbalances. Nevertheless, that should not prevent investors from taking advantage of the current hyper-stimulative environment that should persist for at least another year.”  Now for the bad news.

Storm Clouds Gathering

The BCA editors have never been in the gloom-and-doom camp.  While they have correctly predicted several recessions, they have more often been more positive about the economy than just about anyone I have read over the years.  As discussed on the previous pages, they believe the economy will rebound in the last half of this year and next year.  However, in their July issue, the editors devoted a section to looking down the road at what may happen whenever we hit the next recession.

The editors do not predict when the next recession will hit, but they do point to a pattern in the business cycle where there has been a recession about every 4-5 years, generally speaking, over the last three decades.  As such, they suggest the next most likely time for a recession would be in 2005-2006 or soon thereafter.

The editors paint a picture of what things might be like when we hit the next recession, and it isn’t pretty!

No Levers To Pull Out Of Recession

BCA believes that because of the massive effort being made to reflate the economy now, the Fed and policymakers in Washington will have little ammunition to pull us out of the next recession.  They say:

“The dark side of current reflationary efforts is that they are leading to increased financial imbalances that will cause problems down the road. Consumers are taking on more leverage, government finances are deteriorating dramatically and the bloated current account deficit is continuing to increase. None of these trends are sustainable over the long term.

There have been recurring but misplaced concerns about excessive consumer debt throughout most of the post-WWII period. Nonetheless, this does not mean that debt can outpace income growth indefinitely. Currently, consumer balance sheets are in reasonable shape but that may not be the case in the next economic downturn, especially if housing takes a hit.

There has been a fairly regular four to five-year business cycle in the U.S. in recent decades. This suggests that the next economic downturn could occur in 2005 or 2006. The problem is that the authorities may have limited ammunition in their policy arsenal with which to try and rekindle growth.

Fiscal options will be limited given current trends in the deficit, the dollar will have already fallen significantly, and interest rates may still be below equilibrium levels. Thus, the threat of a debt deflation will be even greater in the next recession than it is today.

With limited policy levers at their disposal, there will be tremendous pressure to try and devalue debt burdens via increased inflation. That, of course, would create even more instability in the dollar and could trigger turmoil in the bond and stock markets.

Whether the 50-year supercycle of debt and illiquidity will come to a traumatic end in the next recession remains to be seen. It is always possible that the economy will continue to benefit from positive supply-side developments, allowing it to sustain rising financial imbalances for several more years. However, the U.S. cannot postpone its financial adjustments indefinitely.”

Translating This “BCA-Speak”

As discussed earlier, BCA expects the economic recovery to continue through 2004, barring any major negative surprises.  In order to do that, BCA believes the Fed will keep short-term interest rates at the current (or near current) very low levels, unless the economy should begin to grow above a 3-4% rate.  Even if the economy does surprise on the upside, BCA believes that the Fed will be very slow to raise rates.  The point is, when we hit the next recession, interest rates will be lower than in any recession in the last 30 years, and the Fed will have little room to stimulate.  Even if short rates were to move back up to 3-4% by the time the next recession hits, that leaves the Fed with few bullets to reflate the economy.

As discussed earlier, the record large budget deficit, now predicted to top $400 billion, is actually helping to stimulate the economy.  But with large budget deficits projected for the next several years, this doesn’t leave Congress a lot of room to increase spending to stimulate the economy in the next recession.  Increasing the deficits from current record levels could well send the bond market into the tank.

BCA also notes that the trade deficit will still be enormous in 2005-2006.  Even with the recent decline in the dollar, the trade deficit is still rising.  By 2005-2006, the bear market in the dollar is likely to have run its course, and it will be difficult and dangerous to take it even lower to help stimulate the economy in the next recession.

Finally, we come to the consumers.  For the last two years as the gloom-and-doom crowd warned us that consumers were tapped-out, BCA has maintained that consumer debt was not nearly as bad as the numbers indicated.  It was BCA who consistently pointed out that 70-80% of all consumer debt was in the form of home mortgages which are very well collateralized.  However, as you read on the previous page, BCA is concerned that in the next recession, consumer debt may be a serious problem, especially if it continues to rise over the next couple of years.

This will be especially true if housing prices come under pressure in the next recession.   BCA believes this is a real possibility.  Housing prices managed to continue to rise in the 2000-01 recession, but we should keep in mind that the ‘00-01 recession was the mildest in the post-war period.  If the next recession is worse, as BCA expects, home prices could very well come under pressure.  Falling home prices will do much more damage to consumer confidence and spending than a bear market in stocks.

Recession &A Debt Deflation

After all these years of subscribing to BCA, I think I read between the lines pretty well.  It is clear to me that BCA expects a serious recession whenever the next one arrives.  I expect they will have a great deal more to say about this prospect in upcoming issues.

Over the last two years, the BCA editors have consistently felt that deflation would not take hold in the US, unlike the gloom-and-doomers who promised that we were headed into a deflationary debt spiral.  BCA maintained that the Fed understood the risks of deflation and was committed to avoiding it.  They were correct.  However, the BCA editors do NOT rule out deflation in the next recession.  They say: 

“Thus, the threat of a debt deflation will be even greater in the next recession than it is today.”

This is serious stuff!   BCA does not sound alarm bells lightly.  They are clearly very concerned about what may happen in the next recession.

When BCA refers to a “debt deflation,” they are referring to a serious recession and/or depression in which prices fall significantly.  In this scenario, much of the debt is simply defaulted upon.

Will We Just Inflate Our Way Out?

The Fed has not resorted to monetizing our debt by printing money in the recent economic downturn.  However, if the next recession is a serious one, the odds increase significantly that they might resort to the printing presses once again in an effort to inflate our way out of the recession.  This is, in fact, what many of the gold bulls are betting on.

The question is, would that work, or would it only make matters worse?  BCA believes the latter:

“What will the authorities do when the economy suffers another slowdown and the threat of a debt deflation is even greater than it is today? In the absence of another positive supply-side development, the only way out may be to start printing money in order to create inflation. The Fed is trying to create inflation in the current cycle, but it has not had to resort to extreme moves such as monetizing government debt. We do not believe it will have to engage in such extreme measures this time, but that may not be the case in the next down cycle...”

Here is how they summarize what’s happening now and what they fear lies ahead whenever we hit the next recession:

“In the near term, the Fed's imperative is to get the economy back on track and avert deflation. If greater imbalances are created, with bearish long-term implications, then that is tomorrow’s problem. Such a view is understandable, but of course it lies at the core of the supercycle process...

By keeping interest rates below their equilibrium level for an extended period, the Fed will force-feed the economy and financial system with liquidity. This is certain to create many different distortions, bubbles and excesses. The danger will be when the time comes to begin re-normalizing [increasing] rates. It is hard to see how the Fed can do this without causing turmoil in the markets.

From a longer-term perspective, today’s massive policy stimulus is raising the stakes for the next recession. The balance sheet pain of an economic downturn will be even greater next time around given the recent sharp rise in consumer leverage and the prospect of a further increase in the current account deficit.”

The Temptation To Inflate

BCA continues on what would likely happen if the monetary leaders resort to inflating the currency in the next recession:

“The only way to avoid a destructive end to the supercycle process may be to try and devalue accumulated debts through increased inflation. That will not be a painless process for the markets...

Clearly, bond vigilantes will resist efforts to create inflation, but if a central bank wants to devalue the currency, it has the power to do so. Destroying accumulated debts by inflation may be the only way to prevent a catastrophic deflationary end to the supercycle process.

Of course, renewed inflation will not be a panacea because it would lead to further potentially destabilizing dollar weakness, and yield spikes in those bonds that were not being manipulated by the Fed. Moreover, a return to inflation would not stop the economy from going into recession: in some ways, it would make it even more likely. The next several years are going to be anything but dull in the financial markets...”

Conclusions

As you’ve read, BCA expects the economy to improve to a 3-4% growth rate by the end of this year, with a good 2004 to follow.  They believe investors should be long stocks and equity mutual funds which should benefit from low interest rates and a recovering economy.  They also believe investors should be moving out of Treasuries and into high-yield bonds.  They believe the dollar will continue to fall, and they are mildly bullish on gold.

But whenever the next recession hits, perhaps in 2005 or 2006, they expect it to be a serious one.   They do not rule out a debt deflation and/or a financial crisis.  These are strong words from the editors at BCA.

Of course, no one has a crystal ball, not even BCA.  A lot can happen in the next 12-18 months.  Maybe BCA’s views will change.  And there is always the chance I have read more into their latest issue than they intended.  In any event, I will keep you posted as to their latest thinking.

What To Do Now

I believe the best way to get back into the stock markets, or add to your positions, is with the market timers we recommend - Niemann, Potomac, Hallman & McQuinn - who are all up nicely for the year.  If possible have accounts with at least two of them for diversification of strategies.  As for bonds, Capital Management Group specializes in high-yield bonds and is having a stellar year.

As noted earlier, our futures funds are having another good year, although we gave back some profits in June.  I believe these funds will serve us well, not only in the near-term but especially when the next recession arrives.  We do have one futures fund that is currently open to accredited investors.  (Past results are not necessarily indicative of future results.)

Editor’s Note

The following article appeared in my July 1 weekly F&T E-Letter.  Those of you who get the weekly E-Letter have probably already read it.

A Dozen Trillion Here, A Dozen Trillion There…

Last month, we got to see the results of a major study commissioned last year by then Treasury Secretary Paul O'Neil regarding the “real” size of the government's unfounded liabilities.  The startling study concluded that the “present value” of the US government’s future obligations was a cool $44 Trillion in the red!  Yes, that's $44 Trillion, with a "T."

You would think that a story about a $44 trillion cover-up would be front-page news every day for months on-end.  The Democrats and liberal media would love to bludgeon Bush with such terrible news.  However, few mainstream media sources, newspapers and other sources have followed up on the story and, other than various places on the Internet, the story has almost completely faded from view. There is a reason for that.

It turns out that the $44 trillion is a bogus number, at least as far as I, and many other more qualified sources, are concerned.  Let me explain.

As mentioned above, the Treasury Department commissioned the study to help policymakers evaluate various scenarios when considering changes to Social Security and Medicare.  As you know, one of the Bush Administration’s [stated] big plans is to privatize part of Social Security and allow taxpayers to invest it themselves.

In many governmental reports, Social Security and Medicare expenditures are projected out over the next 75 years.  Just imagine how difficult it is to project all of the factors that will affect Social Security funding for 75 years.  That’s 75 years’ worth of changing inflation rates, interest rates, life expectancies, health issues, health-care costs, etc. - just to name a few.

However, when privatization was factored in, it showed to be very expensive over a 75-year time window because the full benefit of privatization would not be realized until toward the end of that period.  Therefore, the Treasury-commissioned study pushed out the timeframe for projections to ETERNITY.  Come on, who can predict 75 years out, much less eternity?

Report Turns Out to Be A Joke, More Or Less

The report is flawed for several good reasons.  First, the accuracy of projected values 75 years into the future is questionable at best.  Projecting out in perpetuity (forever?) is simply impossible.  Next, a very small adjustment in the projected interest rates or inflation rates could produce a huge present-value effect due to the power of compounding.  A one-half percent difference in inflation or interest rates could make a difference of trillions of dollars.

Finally, the report seems to imply that, if the government had the extra $44 trillion today, it would invest it wisely for the future and not spend it on pork-barrel projects or tax cuts.  To me, this is the biggest flaw of all - assuming that politicians will act responsibly when considering the effects of their actions on future generations.  And who knows if the public would want the government running huge surpluses.  In any event, had politicians acted responsibly in the past, we wouldn't have the problems with Social Security and Medicare that we do today. 

Most importantly, the report shows that 2/3 of the $44 trillion comes about AFTER the 75-year time window usually used for Social Security analysis.  Recent estimates peg the shortfall at the end of 75 years at only $16 trillion vs. the $44 trillion over perpetuity.

You may be thinking… $16 trillion or $44 trillion… who cares?  It still spells a financial disaster.  Actually, this is exactly what I have thought for many years.  But there is some very good news on the horizon, or at least some potentially very good news for the long-term.

As I will discuss below, this $16 trillion shortfall may be substantially offset (or even more than offset) by an under-estimated stream of future tax revenue.

The $12+ Trillion Tax Windfall

A hot new working document is making the rounds in Washington circles and elsewhere that has politicians licking their chops!  In short, the new research study concludes that there will be a huge tax windfall of $12 trillion or more between now and 2040, resulting from taxes that will be paid on money coming out of retirement accounts during that period.

As you know, if you have money in a retirement account (IRA, 401(k), pension plan, etc., etc. - anything but a Roth IRA), you will have to pay taxes on that money whenever you take it out.  While government number-crunchers factor these retirement tax revenues into their annual budget projections, apparently no one has forecasted the effects of these tax revenues over the next 35-40 years - generally the same time as the worst of the Social Security and Medicare crisis is expected to occur.  Well, now someone has.

Hoover Institution economist, Michael Boskin, has just released a preliminary 131-page research study which estimates that the taxation of pension assets, including IRAs, 401(k)s and all other retirement plans (except the Roth IRA) will yield a $12 trillion (in today's dollars) windfall to the federal government between now and 2040.   And maybe even more.

Not surprisingly, this new study has already caused some politicians to declare that the gloom-and-doom predictions over the nation’s dangerous financial imbalance (Social Security, Medicare, etc.) have been greatly overstated for years.  And they might be correct, but the devil is in the details, as always.  You can expect to hear much more about this in the days and weeks ahead.  So, let me outline the details in advance.

According to the Federal Reserve, there is currently apprx. $11 trillion in the various retirement plans around America (IRAs, 401(k)s, pension plans, federal, state and local retirement funds, etc).  If Americans had to pay taxes TODAY on all the money in their retirement plans ($11 trillion), that would generate apprx. $3 trillion in tax revenues based on current tax laws.  But because these taxes will be paid over the next 35-40 years, the number will be much higher.    

In addition, we have to consider that Americans will continue to contribute more and more money to their retirement plans over the years ahead.  And we have to consider that these assets contributed to retirement plans will continue to compound and grow over the next 35-40 years and longer, even as the supposed Social Security/Medicare crisis unfolds.

The bottom line is, Boskin's study concludes that the aggregate taxes on the nation's retirement plans will total at least $12 trillion between now and 2040.   And it could be substantially higher depending on several variables.  If Boskin is accurate, the Social Security/Medicare crisis could be vastly overstated!  You’ll be hearing a lot more about this in the future.   I will be especially interested to see how the gloom-and-doom crowd reacts to it.  My bet is that they will run with the bogus $44 trillion debt number and ignore the great news about the retirement tax windfall!

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