Most of the economic reports released in September were positive.  The Commerce Department reported that GDP rose at an annual rate of 3.3% in the 2Q, which was above expectations and the previous estimate of 3.1%.  Several surveys of economists now suggest that 3Q economic growth will land in the 4-5% range.  The Index of Leading Economic Indicators rose again in August, continuing the upward trend since March.  Consumer spending jumped a strong 0.8% in August following the gain of 0.9% in July.  If this pace held up in September, it will be the strongest quarter for consumer spending since 1985.   The economic recovery continues.

While the unemployment rate peaked earlier this year, job creation remains weak.  However, the latest unemployment report for September actually saw a rise in jobs for the first time in eight months.  This could be the first meaningful sign that the employment slump has turned up.

The Bank Credit Analyst remains positive in its economic outlook for the next year or longer.  They also remain positive in their outlook for stocks over the same period and view the recent weakness in the major indexes as another buying opportunity.  They remain negative on bonds, especially Treasury bonds.  I share more of BCA’s latest thinking with you in the pages that follow.

While T-bonds have been a roller coaster recently, the improving economy is actually good for the high-yield bond markets.  As a result, our recommended bond timer, Capital Management Group, is having one of its strongest years ever.   I have enclosed our latest Advisor Profile on CMG, complete with their past performance and program information, for your review.  Ihighly recommend you take a look at this excellent program.

Market timing has gotten a bum rap recently due to the mutual funds/hedge funds after-hours trading scandal.  New York’s Attorney General unfortunately chose to describe the illegal mutual fund trading activity as “market timing.”   The fact is, market timing in the traditional sense, and as we practice it, is perfectly legal.  I’ll clear up any confusion for you in this issue of F&T. 

Still Upbeat

If you have been reading this newsletter for long, you know that BCA has been optimistic that the US economy would post a nice recovery for over a year now.  During much of last year, the BCA editors maintained that the US would avoid a deflation problem that was widely predicted by others.  Now, as we’ve seen, the economy is well into the recovery BCA predicted, even though job growth remains a problem.  As you will read below, BCA remains optimistic about the economy for 2004, and they believe that job growth will improve in the months ahead.

BCA also remains optimistic regarding stock prices.  They believe that stocks will move even higher over the next year, and that investors should use occasional periods of weakness, as we saw in late September, as buying opportunities. 

Here are excerpts from the October issue of BCA:

“The Wall of Worry is Intact

Discussions with a broad range of clients confirm that there are still widespread concerns about the outlook for the U.S. economy and equity market. The list of issues has not changed much, even though the economy has surpassed expectations this year and equity prices have rallied strongly. Long-standing and continuing areas of concern are consumer sector finances, excess capacity, the current account deficit, and equity valuations. More recently, persistent weak job growth has moved up the list.

The bearish case is certainly very easy to understand. There has been a dramatic increase in leverage throughout the U.S. economy, the fiscal position has deteriorated dramatically, and the threat of an interruption to foreign capital inflows hangs like the sword of Damocles over the financial markets. At the same time, neither equities nor bonds offer compelling value. This explains why so much money is still sitting on the sidelines, earning a negligible return.

There is an old Wall Street saying that a bull market has to climb a wall of worry. The idea is that as long as investors are nervous, the opportunity exists for positive surprises to draw more money into the market.

We see no reason to alter our view that the economic recovery will continue to gain traction. Record policy stimulus is working with solid consumer spending being increasingly supported by business spending. The job market is still disappointingly weak, but there are signs of a looming improvement. Thus, the odds are still good that the economy will continue to surpass expectations in the months ahead.

We have been emphasizing reflation trades during the past year: stocks over bonds, corporate bonds over Treasurys, cyclical over non-cyclical stocks, and commodity-related investments. This strategy has worked well, and we do not believe that it has fully run its course.

The economy is on track to grow by around a 4% pace in the fourth quarter and at an above-trend pace in 2004 (i.e. greater than 3¼%). We cannot expect consumer spending to accelerate [although it did in July and August] given the lack of pent-up demand, but that is not a requirement for a sustained economic recovery. As long as real consumer spending grows at a 2½% pace or better, the economy should do fine. Of course, this in turn requires that employment growth improves  in the months ahead. Fortunately, there are good reasons to expect this to happen...

The combination of extremely low interest rates, an improving picture for the economy and corporate earnings creates a positive background to the equity market. ...the low level of short rates should provide a solid floor to the market. Those investors who have remained heavily in cash this year have seen their portfolios dramatically underperform. The cash mountain has peaked, but remains very high by historical standards, creating the potential for more money to flow into stocks as economic optimism improves.

The Federal Reserve is continuing to emphasize that it expects to keep its current highly stimulative monetary stance for a considerable period. This is a very vague commitment and discussions with Fed policymakers suggest that it means different things to different people. Nevertheless, it is safe to assume that the Fed will not raise rates until the unemployment rate is clearly falling, and that will take at least several more months...  The bottom line is that the earliest we should expect the Fed to tighten would be the second quarter of next year.”

BCA Still Has Long-term Concerns

In the July issue of F&T, Ireported to you that BCA voiced some very serious concerns about the US economy whenever we hit the next serious recession.  BCA is concerned that our growing financial imbalances (budget deficits, trade deficits, consumer indebtedness, etc.) and the Fed’s lack of additional monetary ammunition could lead to a very serious economic downturn and a possible financial crisis whenever we hit the next recession.  You can re-read that July newsletter at my website www.profutures.com .

The editors at BCA remain concerned about the long-term problems facing the USeconomy:

“It is important to emphasize that we are positive toward stocks only from a cyclical perspective [12-18 months]. The longrun outlook is uninspiring, and we expect to adopt a more cautious stance when the liquidity environment becomes less supportive.

We have promoted what we call reflation trades [stocks over bonds, etc.] because of our view that policy would succeed in triggering an economic recovery. Nevertheless, this does not mean we are complacent about the long-run challenges posed by the build-up in financial imbalances throughout the U.S. economy.

...we have written extensively over the years about the dangers inherent in rising leverage and deteriorating balance sheet liquidity. Ever-increasing debt burdens raise the downside risks for the economy during recessions, putting pressure on the authorities to do whatever it takes to prevent a destructive cycle of debt liquidations, falling asset prices and declining  activity from taking hold. Thus far, they have been successful.

The bursting of one of the greatest asset bubbles in modern times at a time of record debt ratios might reasonably have been expected to end extremely badly. However, unprecedented combined monetary and fiscal stimulus succeeded in averting disaster, albeit at the cost of pushing leverage even higher.

This raises the stakes for the next economic downturn, and it is not clear what policy levers will be available at that point to keep the economy from going over the edge. If the economy suffers another recession within five years, then there may not be much scope for a fiscal easing. The budget will still be in deficit at that point and the fiscal problems related to an aging population will be within sight. [Emphasis added, GH.]

Currently, that problem seems far enough away that it does not weigh on policy decisions. That will not continue to be the case. Meanwhile, it is likely that the dollar will already have depreciated sharply by that time, removing that potential source of stimulus. Presumably, short-term interest rates will be much higher in five years than they are today, so there will be scope to ease monetary policy again. Whether that will be sufficient to turn the economy around will depend on the severity of the downturn.”

BCA concludes its October analysis as follows:

“Investment Conclusions

The U.S. economy is moving on to more solid cyclical foundations, although an improved labor market is still a final necessary condition to ensure that a self-reinforcing upturn is taking hold. This should occur in the months ahead.”

Actually, the latest unemployment report for September suggests that job growth may have finally turned around.  While the unemployment rate remained unchanged in September at 6.1%, non-farm payrolls increased by 57,000 jobs last month.  That is the first increase in eight months and may signal that the final link in this recovery - jobs growth - is finally taking hold.

BCA continues: “There is still tremendous skepticism about the outlook and this gives us confidence that there is still upside left in our reflation strategy because of the potential for investors to be pleasantly surprised by economic developments. Thus, we continue to recommend above-average positions in stocks and below-average positions in bonds.

Fixed-income positions should continue to emphasize corporate securities rather than Treasurys. Spreads have narrowed considerably this year, but there is still scope for more corporate outperformance.

The stock market is vulnerable to a further period of near-term softness [late September selloff]. Those investors who are still cyclically under-weight equities should use this as a good opportunity to increase positions. The stock market will not be at major risk until the Fed starts to drain liquidity, and that is at least six months away.” [Emphasis added, GH.]

Analyzing The Analyst

Clearly, BCA remains optimistic about the US economy for the next 12-18 months, barring any major negative surprises (terrorist attacks, etc.).  They expect the US economy to reach a 4+% growth rate in the 4Q and on into the first half of 2004, at least.

The BCA editors also clearly believe that US stocks have further to run on the upside during this period as well.  It is telling (to me at least) that the editors would advise investors to buy stocks on any pullbacks, such as we saw in late September, even though stocks are up sharply for the year already.  This suggests that the editors believe stocks could have more than a little left on the upside.

While I did not quote their specific analysis of the bond market, the editors continue to be bearish on bonds, especially Treasury bonds.  They believe that long rates will resume their upward trend which began in June as the economy continues to get stronger.

Recently, the BCA editors suggested that investors consider high-yield bonds as an alternative to Treasuries and high-grade corporate bonds.  That was a good call since high-yield bonds tend to do well when the economy comes out of recessions. 

Finally, the BCA editors restate their concerns about the long-term problems facing the US.  They are very concerned about the alarming rise in debt at the government level, the corporate level and the consumer level.  They are also concerned that the Fed may not have sufficient monetary ammunition to fight the next recession, especially if short-term rates remain relatively low for the next 2-3 years.  Simply put, the editors are very concerned that the next recession, if it comes in the next few years, could be very serious.

Action To Take

While BCA has been optimistic about the economy all year, and they have been bullish on stocks for several months now, I know that many of our clients have not moved back into stocks due to concerns that the bear market is not over.  Certainly, no one can say for sure that the bear won’t return.  However, this is the classic case for using market timing strategies.

At the risk of sounding like a broken record, I continue to recommend that you consider some of our market timing programs for the current market environment.  All of our recommended timing programs are profitable this year, and several are having one of their strongest years ever.  (Past results are not necessarily indicative of future results.)

Icontinue to recommend that you consider Niemann Capital Management and Potomac Fund Management for a good portion of your equity portfolio.  Both of these programs can go 100% to cash if the bear market should resume, and they both have implemented “hedging” techniques in the last year or so with the goal of reducing losing periods.

As noted above, I also continue to recommend Capital Management Group for a portion of your bond portfolio.  CMG is having one of its best years ever this year.  Please review the enclosed Advisor Profile on CMG to see if this very successful program is suitable for you.  The minimum investment is only $25,000.

Call us at 800-348-3601 for more information.

The Hedge Fund / Mutual Fund Scandal

On September 3, we read in the financial papers that a large hedge fund had agreed to pay $30 million in restitution of illegally obtained profits from after hours mutual fund trading, plus a $10 million penalty for doing so.  The hedge fund noted in the announcement was Canary Capital Partners LLC and is reportedly part of a much larger investigation into such practices by New York’s Attorney General, Eliot Spitzer.

Canary (and perhaps other large hedge funds) allegedly obtained special trading opportunities with several leading mutual fund families - reportedly including Bank of America’s Nations Funds, Banc One, Janus and Strong - by promising to make substantial investments in various mutual funds offered by these firms.

The special trading opportunities, in this case fraudulent trading opportunities, consisted primarily of so-called “late trading” of mutual funds after the stock markets close at 4:00 eastern time.  If you or I, for example, want to make a purchase or sale of a mutual fund, we have to get our orders in to the fund family before the close of the markets, sometimes 30 minutes or more before the markets close. If you or I place our order after the markets close at 4:00 today, then we don't get that order filled until tomorrow at the 4:00 closing price.

In the case of Canary, the mutual funds noted above (and possibly others) allegedly allowed Canary (and others) to place its orders AFTER the markets closed and still get the closing price for the same day.  As you know, there are frequently announcements just after the markets close that can have significant effects on the markets the following day.  Allegedly, these hedge funds would trade on this after-market information and reap big profits the following day. 

Allowing large hedge funds to trade after hours is illegal and it serves to reduce profits and/or increase losses to the other shareholders of the mutual funds! 

Why Would The Fund Families Do This?

What is most surprising to me is that these very large mutual fund families would have engaged in these illegal practices, in the first place, and apparently for several years in some cases.  The answer, as usual, is making more money.  According to information disclosed by Eliot Spitzer, Bank of America made $2.25 million per year from these companies and/or hedge funds in special payments and other incentives.

The investigation of illegal trading at mutual fund families is ongoing.  More fund families may be cited in the weeks ahead.  Obviously, as this information is made public, it will be bad news for the fund families that are cited.  For example, Morningstar has already released a statement advising investors to move their money out of the four fund families (noted above) named by Spitzer in his complaint.  If the scandal is larger and if other mutual fund families are cited, then Morningstar will be hard pressed not to offer the same advice for them.

“Market Timing” - A Bad Choice Of Words

When NYAttorney General Eliot Spitzer made his announcement on September 3, he referred to this illegal after-hours trading as “late trading” which is accurate.  But he also criticized the hedge fund’s use of short-term trading, and in doing so used the term “market timing.”   This has led to a flurry of misplaced negative discussion about market timing.  As a result, I want to take this opportunity to set the record straight.

What these funds were doing is NOT an accurate characterization of market timing, in my opinion.  The short-term trading of mutual funds that Canary (and apparently others) was doing is not illegal.  It was the after-hours trading that was illegal.  The term market timing, as most of you reading this know, does NOT relate to the fraudulent, after hours trading that was discovered by Spitzer's investigation.

Some mutual funds discourage short-term trading because it can cause problems for the fund managers if large blocks of money move in and out of the funds frequently.  So, some funds actually prohibit such short-term trading in their prospectuses, and they retain the right to redeem (force out) customers who trade too frequently.  The four fund families noted above actually had such prohibitive policies on short-term trading in their prospectuses.  

Mr. Spitzer said the funds operated under a “double standard,” in that the Canary fund and apparently other big players were allowed to execute short-term trades even while everyone else was precluded from doing so.  Again, the problem is not that short-term trades are illegal.  In fact, there are numerous fund families such as Rydex, ProFunds and others that actually welcome short-term trading and were specifically designed to accommodate such rapid trading. 

In addition to allowing short-term trading when their stated policies prohibited such practices, the funds named above also allegedly allowed Canary and others to place such orders after the close of the markets, which is clearly illegal.  This is not market timing as we all know it.  Yet due to the latest publicity, Ifeel the need to make the distinction.

Market Timing In The Traditional Sense

As you know, market timing is a strategy that involves moving in and out of the market periodically in an effort to miss portions of the downward moves in stocks, while being in the market for significant portions of the upward moves.  In theory, market timing would allow investors to reduce their risks during downtrends in stocks and bonds, while still earning at least market rates of return on the upside.  Market timing is practiced by many individual investors and many professional Investment Advisors.   It is in fact a very legitimate and legal investment strategy.  However, because Mr. Spitzer chose to use those words - “market timing” - in his announcement, some investors who are not familiar with traditional market timing have confused it with the fraudulent activities discussed above.  Nothing could be further from the truth!

To help combat the perception that market timing is somehow illegal, the Society of Asset Allocators and Fund Timers, Inc. (SAAFTI), an association of Registered Investment Advisors who practice market timing and other active management strategies, issued a rebuttal to Mr. Spitzer’s use of the term “market timing.”  The following excerpt from SAAFTI’s press release sets the record straight:

“Members of SAAFTI are recognized, registered and regulated by the U.S. Securities and Exchange Commission and individual state securities administrators. Their trading strategies are acknowledged by the regulators and their practices are regularly reviewed for compliance with state and federal regulations. Many have used timing strategies for over three decades… There is absolutely no relationship between the strategies employed by these investment firms -- who conduct their investment management business in accordance with the rules promulgated by the SEC and state regulatory authorities -- and the example cited by Mr. Spitzer.  To draw such an inference is both irresponsible and a disservice to the investing public.”

I could not agree more!   So, if you should read negative comments about market timing, within the scope of the recent mutual fund/hedge fund scandal, just keep in mind that this does not refer to market timing as we practice it.  Also, keep in mind that this latest flap over market timing, however misplaced, plays right into the hands of the mutual fund industry and to some extent, Wall  Street.  The mutual fund community (with the exception of Rydex, ProFunds and others who invite market timing) and to some extent, Wall Street have criticized market timing - as we practice it - for years.  They have continually argued for a “buy-and-hold” strategy. But you know differently, especially in light of the September issue of F&T wherein I presented “The Definitive Case For Market Timing.”  Market timing, as we practice it, is a very valid investment strategy, especially in the market environment we have seen over the last three years of the bear market.