The economy continues to improve.  GDP soared 5.8% (annual rate) in the 1Q according to the government's latest report.  The gloom-and-doom crowd is reeling after this one.  Manufacturing expanded for the fourth month in a row, after 18 down months in a row.  The rebound in the manufacturing sector has been largely due to inventory rebuilding, and this led to the higher than expected GDP number.

Several reports released in April showed slower growth than we saw in February and March.  This is very consistent with my prediction last month that the economy would not continue to expand at the rate it did in the 1Q.  I continue to believe the economy will settle down at a rate of about 3-4% for the year overall, assuming there are no more negative surprises.

Alan Greenspan and several other Fed governors have made it clear they see no need to raise interest rates in the near-term.  I would not be surprised if all we see this year is a couple of quarter-point increases late in the year, provided that inflation does not become a problem.

The stock markets have all the ingredients in place for a bull market- stimulative monetary policy, low inflation, consumer confidence and improving earnings - yet the markets continue to languish.  Investors are not coming back into the market as they historically do when the economy comes out of recession.  I still believe it will happen, but it may be later than sooner.  The Bank Credit Analyst continues to believe stocks will be considerably higher by year-end.  They continue to recommend stocks over bonds.  There certainly appear to be some very good bargains in the large cap value sector today.

In this issue, among other things, we will examine the issue of consumer debt.  For months now, we've been told that consumers are "tappedout" with record debt.  As you will see, there is plenty of evidence indicating that consumer debt levels are not as troublesome as many would have you believe, which explains how the economy has rebounded so strongly.

If you are not reading my e-mail Special Updates, you are missing out on a lot of great information.  Check them out at www.profutures.com

On The Economy In General

If you will remember, late last year mainstream economists and the media were predicting a recession at least until the middle of this year.  Most thought the economy would do well to end the year on a positive note.  I never got that negative on the economy, largely because The Bank Credit Analyst never did.  Likewise, I have not been nearly as optimistic as the mainstream economists and Wall Street analysts have become over the last few months.  While most economists and brokerage pundits have revised up their estimates to 5-6% GDP, I have been saying it will probably end-up around 3% to maybe 4% for the year.  I still believe that, barring any more negative surprises, including any more major terrorist attacks.

The 1Q GDP growth of 5.8% (annual rate) surprised everyone (at least that I know of).  The gloom-and-doom crowd was in "fits" when this number came out.  Many are arguing that this number is bogus.  Don't buy that argument!  They've used it for years.

The Inventory Effect

Over half of the big surge in 1Q GDP came from inventory rebuilding.  If we exclude inventory buildup, GDP was only up 2.6% in the 1Q.  Assuming inventories are reasonably rebuilt by now, future growth in GDP will be governed largely by consumer spending and business spending for buildings, equipment, software, etc.  In the 1Q, such capital spending actually declined 5.7% (annual rate).  Given these facts and other info below, we should expect GDP for the 2Q to be well below the 5.8% pace in the 1Q.

Several economic reports released in April were down from February and March levels.  The unemployment rate for April, for example, jumped from 5.7% to 6%; however, this has been widely expected for some time.  Consumer confidence dropped slightly in the latest report.  Yet the news was not all bad in April.  Auto sales were up 2.8% in April, and manufacturing rose for the fourth consecutive month.

We're Not Going Back Into Recession

The media, which has swung back and forth like a yo-yo, has of late been voicing serious concerns about the latest negative economic reports.  If you listen to some commentators, you'd think we're headed back into recession.  We're not, barring some major surprise.   The 5.8% rise in 1Q GDP virtually assures that.  The evidence we have today suggests that, worst case, the economy would average 1½-2% for the year, and probably more like 3-4%.  This is consistent with BCA's latest May analysis.

Actually, the most concerning thing about the economy of late is the stock markets.  Typically, stocks are a leading indicator of the economy.  Stocks rebounded quickly after the 911 sell-off, but since the first of the year most of the broad indexes have been in decline, especially recently.  This is unusual because the environment is so right for equities: low interest rates, lots of liquidity, a ton of cash sitting in money markets earning next to nothing and an economy that is clearly on the rebound.

The current situation is clearly different and appears to be a simple matter of overhead resistance.  Many investors are disillusioned with equities, what with the tech wreck, the 911 sell-off and the Enron's of the world.  Many people just want out.  Even though a lot of money went into money market funds just after 911, there are millions of investors who are still in the market and are still "under water."  It is hard to quantify the overhead resistance impact on the markets, but if we look at mutual fund purchases versus redemptions over the last 5-7 years, it could be very significant.

It remains to be seen if the very positive market conditions and improving confidence will bring enough money back into the market to overcome overhead selling pressures and generate a new bullish trend.  BCA continues to believe a new upward trend will develop but admits it has taken longer than they expected. 

This is another argument for market timing strategies in your equity investments.

Many Say Yes

We have all heard the concerns about the financial position of US consumers.  Household debt reached 109% of personal disposable incomes at the end of last year, a new all-time high.  At the same time the "official" personal savings rate was a mere 1.6%, the lowest level since the depths of the Great Depression.

The gloom-and-doom crowd loves to use these figures to scare you out of your traditional investments and into their often crackpot schemes, precious metals coins and other obscure "investments."  Of course, these people fail to admit they have been sounding this same alarm for the last 20-30 years as they have managed to scare untold numbers of investors out of the greatest equity bull market in history!

The gloom-and-doomers are not alone.  Many mainstream publications quoted these same personal debt/savings figures last year when they said the economy couldn't rebound after 911.  Yet consumers are still spending, and the economy has rebounded more strongly than just about anyone imagined.  We also hear this said today to explain why the stock markets won't go up.  So how will they explain it if the stock market moves into a new bullish trend in the months ahead?  Answer: they won't explain it.  They will simply "forget" that they said it.

What you need to understand is that concerns over consumer debt/savings levels are nothing new.  There have been similar levels of concern over consumer indebtedness several times in the last century.  Most recently, such outcries of concern over consumer debt occurred in the late 1970s and the mid-1950s.

In 1978, then Fed Chairman William Miller warned that American consumers were "dangerously deep in debt," and that the trend could have "serious consequences."  Again, this is nothing new.  I am not suggesting that the current record levels of consumer debt are not a problem.  They are.  But the problem is not as bad as many would have you believe, and many of the numbers are no longer accurate.

The Numbers Are Overstated

In this article I hope to debunk some of the myths about consumer debt/savings.  This discussion is not to suggest that consumer spending is going to expand significantly,  or that we are going back to the go-go days of the late 1990s.  But it is intended to show that consumer spending is not about to fall off a cliff.

To begin with, household debt as a percent of personal disposable income has risen steadily throughout the post-war period.  After WWII, household debt was apprx. 30% of disposable income.  Today, it stands at 109% as noted earlier.  The only periods when this percentage fell significantly were in the 1973-74 recession and the 1981-82 recession.

Yet looking only at the significant rise in household debt does not tell the whole story.  The gloom-and-doom crowd would have you believe that most of this debt is high interest credit card debt.  That is simply not true.  For example, home mortgages account for apprx. 70% of household debt.  As we all know, home values have risen dramatically in the post-war era.  Here is an interesting figure I didn't know.  The average American homeowner still has apprx. 55% equity in their homes.  This means that the 70% of household debt represented by home mortgages is very well collateralized.  So much for that myth.

The Credit Card Myth

Installment debt has risen steadily as a percent of disposable income as credit cards are increasingly used to buy goods and services.  If you are like me, you use your credit cards as often as possible to build up airline miles and other benefits.  What the gloom-and-doomers fail to point out is the fact that most Americans pay off all or most of their credit card debt every month.  The net increase in outstanding credit card debt represented only 1.3% of consumer spending in 2001.  Also, this percentage has peaked out at a progressively lower level during the last three credit cycles since 1980.  This challenges the widely-held belief that credit card debt is epidemic.

This is is not to say that credit card abuse is not a problem.  It is.  However, the abuse has peaked, and credit card over-use is not widespread enough to cripple the economy.

US Debt Burden Less Than Other Countries

According to the OECD, the US household sector debt burdens (debt as a percent of income) are below those of Canada, Germany, Japan and the UK.  This news should surprise most people.  For years, we have heard that the Japanese are religious about their saving habits.  Actually, Japan's household debt is the highest of all the countries mentioned above.

Japan, you might say, is not a good example because their economy has been in a recession for a long time.  But what about Germany?  When was the last time you read an article talking about dangerously high household debt levels in Germany?

Increased Debt Means Decreased Spending

Analysts continually say that if household debt rises, consumers will have to spend less in the future.  I have long questioned this assumption in the simplest of terms: with debt rising steadily since WWII, how then did our economy grow exponentially during the same period?  One part of the answer is inflation.  Take home prices for example.  As noted on the previous page, home mortgages account for over 70% of household debt.  As we all know, home prices have risen dramatically since WWII.  As a result, mortgages have increased dramatically as well.  So have incomes.

Another part of the answer is harder to explain, but I'll give it a try.  In early 2000, the Federal Reserve published a study entitled, "The Growth of Consumer Credit and the Household Debt Service Burden."  This study showed that rising debt burdens are positively - not negatively - correlated with future consumption growth.  In other words, increasing debt does not automatically mean there will be a looming cutback in consumer spending.  Consumers generally take on more debt when they are confident about the economy and their job security.

Bank Loan Delinquencies

The gloom-and-doom crowd loves to cite statistics on bank loan delinquencies and defaults.  I get junk mail that says, for example, that credit card delinquencies and defaults are at an all-time high.  This is not true.  Credit card delinquencies and defaults peaked in 1991 and declined steadily for several years.  While the trend in delinquencies and defaults has moved higher with the poor economy of the last two years, we are nowhere near the peak in 1991.  The latest data available shows that credit card delinquencies are less than 5% of all outstanding cards.  The gloom-and-doomers fail to tell you that.

The delinquency rate on home mortgages is less than 2.3% of the total according to the latest data available.  That is also way down from the peak in 1991.  The delinquency rate on other consumers loans is only   3.2%, also well below the peak in 1991. 

What About Household Assets?

In order to assess household finances, we must  look at assets as well as debt.  For the end of 2001, the government reported that household sector assets were four times greater than its liabilities, and this did not include real estate and durable goods.  If we include those items, assets are six times greater than liabilities. 

The ratio of assets to income is still high by historical standards, even though it is down sharply from the peak reached during the stock market bubble in the late '90s.  The ratio of net worth to income is also above its historical average, but is also well below its peak during the stock market boom.

Household net worth did decline significantly as a result of the 2000-2001 bear market in stocks. In 2001, household net worth recorded its first annual decline of the post-WWII era.  Yet consumer spending did not retrench substantially as economists expected.  One of the reasons is that stock ownership is still highly skewed toward the wealthy.  In addition, the worst destruction in the equity markets was in the tech sector where a significant portion of the stock is (or was) owned by a relatively small number of insiders.  

Those who are wealthy are not as likely to change their spending habits just because their equity portfolio declined in value.  This, many believe, is why consumer spending held up better than expected over the last two years.  And there is another reason.

The Housing Boom

As noted earlier, home prices have risen dramatically in the post-WWII period, and even in the last two difficult years for the economy and the markets.  Yet the "affordability index" remains close to its all-time high.  This means that a family on a median income can easily afford to finance the mortgage on a median-priced home.  Because of this, many more Americans own homes than ever before, and they have been building equity as home prices have risen.

Because mortgage rates have declined so substantially in the last decade, many Americans have used that opportunity to refinance their mortgages.  This has enabled them to either lower their monthly payments or take out some cash to pay down other debt or invest in securities or other assets.  Because home prices have risen so steadily, the average home equity is still 55% even though many (if not most) people have refinanced and taken out some cash.

There are always those who believe that the housing market is a bubble just waiting to burst.  I have heard this ever since I got in the investment business over 25 years ago.  Fortunately, I never bought into it.  Home prices have come down in some areas of the country, and they may fall in others, especially if interest rates rise significantly (which is not expected). I don't think home prices will fall significantly, and the long-term trend is likely to remain higher.

The day will come when a majority of the Baby Boomers have reached retirement, and some observers expect a glut of homes on the market could send prices  into a significant decline.  I suppose this is possible, but I have seen no convincing data on this.  In any event, that's a long way down the road.

The point for this discussion is that rising home prices have fattened homeowners' net worth significantly over the years, during the same time that household debt has increased.  A recent study found that the wealth effect from housing was much greater than that from the stock market.  If this is true, that would help explain why consumer spending remained so strong even in the face of the decline in the equity markets. 

The Low Personal Savings Rate

In addition to the rising debt burden, the gloom-and-doom crowd loves to rant about the low savings rate.  The truth is, the government's complicated method for tracking the savings rate is woefully outdated and is not representative of today's saving rate.  For example, durable goods purchases (including cars) are not included as assets or investments.  If they were, this change would have increased the 2001 saving rate from 1.6% to 4.9%.  But you don't read that anywhere.

Another example is pension benefits.  The government's method for measuring savings does not include benefits paid by pension funds to individuals as income.  The explanation is too long for this discussion, and doesn't make sense anyway, but the pension effect would add another 3% to the US savings rate. 

The official measure of personal disposable income also does not include capital gains, but it does subtract taxes on capital gains.  While this practice might be statistically "pure," it has little relation to how money actually flows in and out of households.  If this practice were changed to a more realistic method, the savings rate would be boosted significantly.

If the three issues discussed above were changed, the US savings rate would have been more than 13% in 2001, not 1.6% as reported by the government. 

If that weren't enough, the government also does not consider any of your investments as savings.  Not even your money market funds or bonds.  If you are like most people, you do consider your various investments to be a part of your savings.  If investments were included, the savings rate would be even higher.

As usual, things aren't nearly as bad as many - especially the gloom-and-doom crowd - want us to believe. 

Outlook For Consumer Spending

The resilience in consumer spending over the last year is nothing short of remarkable.  We had the stock market decline, 911terrorist attacks and the recession.  Normally, that combination would have hit durable goods and housing prices the worst.  Yet consumers kept spending. 

A big part of the credit goes to the Fed which was quick to flood the market with liquidity and cut interest rates repeatedly.  Because the recession was minor, income growth held up better than in previous cycles.  With the economy improving, income growth should improve as well.

There is, however, a downside to the consumer news.  Because consumers did not retrench, as in past cycles, there will not be the big rebound in spending in the current recovery phase.  In the past five economic cycles, consumer spending rebounded at an average rate of 5.1% in the first year of the recovery and 4.7% in the second year.  Don't expect those numbers this year or next year.  Something around a 3% increase in consumer spending would appear more reasonable for this year.

Conclusions

Fears about consumer sector finances are greatly exaggerated.  Clearly, there is a limit on how much income consumers can devote to debt servicing, but we are not there yet.  Clearly, there is a large group of consumers who, either through economic misfortune or bad judgement or both, are in debt up to their eyeballs.  However, if this problem has reached epidemic proportion, as some would have us believe, the loan delinquency rates would be skyrocketing.  They aren't. 

This is not to say that the trend in consumer debt isn't troubling.  It is troubling.  It will have to be dealt with.  If this trend continues, it will be bad for the economy and the financial markets at some point.  But we are not there yet.

The downward trend in the savings rate is also troubling.  Yet as discussed above, the government's "official" savings rate is significantly understated.     

Consumers have been spending at a faster pace than incomes over the past couple of years.  This trend is not sustainable.  Yet this does not mean economic disaster.  As noted above, consumer spending is still likely to increase by around 3% this year, barring any negative surprises.

The gloom-and-doom crowd and the bears will continue to misrepresent debt and savings figures.  However, barring any major negative surprises, this chronically pessimistic crowd will be as wrong in the years ahead as they have been in the past.

What Does All This Mean To You?

We know our clients aren't up to their eyeballs in debt.  We also know they are savers.  Otherwise, they wouldn't have money to invest.  I decided to write about the debt/savings topic this month: 1) because it is so misrepresented in the media; and 2) because consumer spending still drives the economy.

Since November, I have been sharing with you each month The Bank Credit Analyst's forecast for the economy.  And what have they consistently said? The economy would recover and, if anything, would surprise on the upside.  I would certainly say that the 5.8% (annual rate) jump in 1Q GDP more than vindicates BCA's forecast.

While BCA doesn't expect the economy to continue to grow at that rate, they do believe the recovery will continue for at least a couple of years longer and probably more, barring any major negative surprises such as more serious terrorist attacks.

They also continue to believe the stock market will trend higher, although they have clearly been early on this forecast.  This isn't the first time they have been early on market calls, but they have rarely been wrong.  Given their economic forecast and their position on stocks over bonds, you may want to consider the latest downturn in the equity markets as an opportunity to get reinvested. 

As always, we are happy to visit with you about putting your money to work.  Just give us a call.

Twice a year, Barron's conducts a survey of over 150 leading money managers around the country.    Given how awful the market's performance was in April, I would have expected most money managers to be on the bearish side.  April, by the way, is historically the worst month of the year for stocks (tax time). The latest Barron's poll finds that 47% of professional money managers believe stocks will go up during the balance of this year, while only 17% were bearish (the rest were neutral).  The latest poll compares with 67% who were bullish in the Barron's poll late last summer prior to the 911 attacks. 

The consensus opinion was that the Dow (currently below 10,000) will be above 11,000 by the end of the year, up 11-12% from current levels.  The experts also believe the S&P 500 will be above 1225 (currently below 1050), and the Nasdaq will be near 2000 (currently below 1600) by year-end.

While the respondents to the latest Barron's survey were decidedly positive (47% to 17%), most admitted that they are having a much tougher time finding value in today's market.  Historically, cheap stocks have rallied strongly in anticipation of an economic recovery.  Lately, however, blue chip stocks have taken a beating for the most part.  As a result, almost half of the money managers polled said they were struggling to decipher which industry sectors would lead the way in the expected rebound.  A majority believes it will be capital goods and health care that lead the markets higher this year.

The number of bearish managers, 17%, was about the same as in the poll last fall, prior to 911.  Yet a large number of managers that were bullish last fall have now moved into the "neutral" camp, which almost doubled to 36% from the reading last fall.  The bears, on average, expect the Dow to fall to 9525 and the Nasdaq to fall to 1525 by the end of the year.  From current levels, that's not very far.

The managers were polled on their outlook for the economy.  The average prediction was 3% for 2002 and 3.1% for 2003.  They predicted the US economy would be the strongest in the world over the next year, followed closely by Asia.

They expect inflation to remain tame at 1.8% this year and 2.4% in 2003.  They expect interest rates to remain fairly low, with 90-day T-bills yielding 2.5% at year-end and 3.2% by mid-next year.  The average prediction on 10-year T-notes was 5.7% by year-end and 6.0% by mid-next year.

Over 60% of the managers predicted that the US dollar will fall against the Euro during the balance of the year.  But they also believe the dollar will rise against the yen.

Over 63% of the managers believe that corporate profits will be the main market driver for the balance of the year.  The managers, on average, predicted corporate profits growth of 8.1% this year and 10.1% next year.  They predicted an average P/E ratio of 22.6 for this year and 21.8 for next year.

While smaller stocks have ruled the market for the last couple of years, a majority of the managers believes it will be larger stocks that lead the market higher during the rest of this year.  Some of their favorites are listed below.

35% of the managers polled believe that tech stocks will be the weakest performers during the balance of the year, while only 13% thought tech stocks would lead the market higher.  Interestingly, that means that over half the managers (52%) were neutral on tech stocks.

The poll revealed the following companies are the  favorites of the managers:  AIG, Pfizer, Bristol-Meyers, Squibb, General Electric, First Data, Viacom, Aetna, Citigroup, General Motors, Intersil, Texas Instruments, Tyco, Wal-Mart and Wellpoint Health.

The most overvalued stocks: General Electric, Krispy Kreme, Applied Materials, Cisco, Intel, Microsoft, IBM, Ebay, JDS Uniphase, 3M, Amazon.com, Brocade Communications and Yahoo.

[Hint: Over the years, the managers in these Barron's polls have done considerably better at identifying stocks that are losers (overvalued) than they have in picking their favorites (undervalued).  So, I would not recommend that you go out and buy the "favorites" on the preceding page.]

On average, the managers' portfolios are currently allocated as follows, along with projection for next year:

                        Stocks              Bonds               Cash

            Now      68.8%              18.2%              12.9%

            1Year     74.9%             17.4%                7.7%

On average, the managers' equity holding are broken down as follows:

Large Caps    Mid Caps    Small Caps

   60.75%        22.18%         17.07%

When asked the question, "Are you beating the S&P 500 Index this year?" here was the response:

                        YES                 NO

                        70%               30%

Conclusions

My first thought after reading the latest Big Money Poll is that it was surprisingly positive.  For one thing, it's Barron's first poll since September 11th - the world has changed since then, and not for the better.  For another, the poll was taken in late April when the market was tanking, and just about everyone was in a foul mood.  Yet the managers, on balance, were optimistic about the market, about the economy and about corporate earnings.

Remember, these are independent money managers, from all across the country, not the Wall Street brokerage crowd that is always bullish.

My second thought about the latest poll was that the outlook it portends is surprisingly similar to The Bank Credit Analyst's current forecast.  Both BCA and a plurality of professional money managers believe that earnings are going to surprise on the upside, and that stocks will go higher this year and next year.

Both BCA and a majority of professional money managers believe the economy will continue to expand, that interest rates will remain generally low, and that inflation will not be a problem.  The previous sentence should be a prescription for a rising stock market.

But, you say, Halbert, if everything's so great,      why isn't the market moving higher already?

As discussed on page 2, it appears the market is suffering from significant overhead resistance that is slowly being worked off as more and more people are throwing in the towel.  While I can't tell you how long this process will take, trading volume has been low since mid-March.  As a result, I don't think it will take much to turn the market higher.  As this newsletter goes to press on May 8, the Dow Jones is up over 300 points on surprisingly good earnings reports.  That's the best day in a long time!  Maybe the lows are already in; then again, maybe not; only the market knows.

Advisor Updates

So far this year, Niemann Capital Management is up over 6% in its "Risk managed" program, versus the S&P 500 Index which is down over 8% during the same period.  While Niemann's account minimum has gone back up to $100,000, I still think you should consider this program, especially with the market still uncertain. Potomac's Conservative Growth program is up over 3% this year, versus the S&P down over 8%, despite the rough market conditions so far this year.  Potomac's minimum is only $15,000.

If you are under-invested in equities, this may be a good time to add to your holdings.  Both Niemann and Potomac are market timers that can go to cash if market conditions warrant.  Call us for more information at 800-348-3601.