The Commerce Department reported that GDP rose at a blistering annual rate of 7.2% in the 3Q following 3.3% in the 2Q.  Consumer spending was stronger than expected in the 3Q.  Meanwhile, unemployment data has improved over the last two months.  Barring some negative surprise, such as another major terrorist attack(s), the economy should remain relatively strong for the next year.

The Fed says it remains committed to keeping interest rates low.  At their latest FOMC meeting the Fed governors elected to leave short rates unchanged, even though they were aware that a very strong GDP report was about to be released.  Do not be surprised, however, if the Fed begins to nudge interest rates slowly higher later this year or early next year.

Stocks have continued to trend higher on the improving good economic and monetary news.  Since bottoming in March, just before the war, the Dow is up 25% and the S&P 500 is up 27%.  Niemann and Potomac are both having a great year.  If you took my advice in March to move back to a fully invested position in the market, you should be very happy today. The Treasury bond market continues to be very volatile, coming off the huge decline in June-August.  Despite that, Capital Management Group is having one of its best years ever.  If you have not requested information on CMG, Istrongly recommend you do so.

In this month’s issue, I focus on the growing mutual fund trading scandal that has increasingly been referred to as a “market timing” scandal.  The fact is, it has nothing to do with traditional market timing as we know it.   Rather, it has to do with mutual fund families catering to big clients and fund managers at the expense of long-term investors.  Regulators are cracking down on these abuses, as they should.  This month, I discuss the latest developments and the likely ramifications.

You may recall that there is another Gary Halbert in the investment world (he’s Gary “C” and I’m Gary “D”).  While I don’t know him, and we’re not related, Ihave struggled for years to prevent people from confusing me with this  guy.  Well now he’s in trouble with the SEC for alleged securities fraud and has apparently left the country.  See details on page 8.

[Editors Note: While a portion of this article appeared in my weekly E-Letter on October 28, there have been several new and negative developments since then which are discussed below.]

More Negative Press

Mutual funds have continued to receive negative publicity in recent weeks as more fund families have admitted to allowing so-called “late trading” (after-hours trading) and what regulators and the fund industry have chosen to call “market timing.”  As usual, there is a great deal of misinformation out there on these issues, and everyone who is in the regulators’crosshairs is looking for someone else to blame. 

The truth is, there have been mutual fund families that allowed certain large investors to make selective trades after hours (ie - late trading), as alleged by New York Attorney General Eliot Spitzer.  There have been certain large investors who have abused the mutual fund trade processing system - with or without the funds’ knowledge - to their benefit and at the expense of long-term fund shareholders.  And, we are now learning that even some of the fund managers, themselves, have been guilty of short-term trading in their funds’ own shares.  

Both the fund families that have knowingly allowed this practice, and the investors (and fund managers) who participated, should be punished.

As for all the hoopla about “market timing,” you need to understand what is - and what isn’t - market timing, in the traditional sense of this investment term.  You also need to know why the mutual fund industry is using this opportunity to bash market timing to their benefit, even to the point of adding new fees and charges for early redemptions.

In this issue, Iwill bring you up to date on the latest charges and allegations, and tell you where I think this will end up.  If you invest in mutual funds, this is information you need to know. 

Illegal Late Trading Of Mutual Funds

The “late trading” scandal first made news on September 3 when NY Attorney General Eliot Spitzer announced a $40 million settlement with Canary Capital Partners (CCP) , a large hedge fund.  While the details are still not entirely known, it is clear that CCP was allowed to enter mutual fund trades after the markets closed for the day and get the closing NAV for that same day, not the next day.  This is illegal. 

Some believe that CCP had been entering dual orders - both to buy and sell - shares of the same mutual funds on various days.  On days when important news was announced after the markets closed, CCP allegedly was allowed to cancel one of the orders - either to buy or to sell - so as to take advantage of the news and the likely impact on the markets the following day.  This is also clearly illegal.

A Poor Choice Of Words

When Eliot Spitzer announced his surprising findings regarding late trading and the large initial settlement on September 3, he also stated that he was investigating other violations.  Specifically, he said he was investigating mutual funds and fund families that allowed rapid-fire, short-term trading of their shares when their prospectuses prohibited such trading.  If the prospectuses don’t allow it, such trading is illegal.

Unfortunately, Spitzer chose to describe this rapid-fire, short-term trading as “market timing.”  As clients and readers of this newsletter, you know traditional market timing is NOT illegal.  Traditional market timing, as practiced by the professional Advisors we recommend, is a legal and legitimate investment strategy that has been around for decades.  Yet because of Spitzer’s poor choice of words, the media attention has unfortunately cast a shadow over the industry of money managers collectively known as “active asset allocators” or “tactical asset allocators,” also known as market timers. Generally speaking, the money managers that we have come to know as market timers are not short-term traders (more on this below).

Rapid-Fire, Short-Term Trading Abuses

Unless prohibited by their prospectuses, short-term trading of mutual fund shares is not illegal.   In fact, some mutual fund families, such as Rydex, ProFunds and others actually were designed for and welcome short-term trading.  Many traditional market timers use Rydex, ProFunds and others like them.  Yet many funds prohibit short-term trading in their shares.

There are reasons why many funds do not want short-term trading of their shares.  Investors who make these very short-term, rapid-fire trades - often in one day and out the next, as well as day-trading - can cause the funds’ transaction fees and related expenses to rise.  If large blocks of money move in and out of the funds on a very short-term basis, this can also cause the fund managers to buy or sell securities when they would  otherwise have not done so.  This can be detrimental to long-term investors in these funds.

Unfortunately, some fund families allowed short-term trading of their shares even though such trading is prohibited in their prospectuses.  Even worse, some fund families allowed this type of trading only for a select group of large investors and hedge funds, either as a way to keep their business, or in some cases, for compensation.  You may recall that Eliot Spitzer alleged that Bank of America made an extra $2.25 million per year from these large investors and hedge funds in special payments and other incentives.

Worst of all, we are now learning that certain fund families allowed (or did not stop) some of the actual mutual fund managers to short-term trade the very funds they manage for personal profit.  At least one CEO of a prominent fund family is alleged to have conducted illegal short-term trading of the funds his company offers.  Again, this activity is illegal because it is prohibited in their prospectuses. 

As this is written, the SEC and Massachusetts regulators have charged Putnam Investments and two of its fund managers with securities fraud for short-term trading in their funds.  According to the Wall Street Journal, the SEC has subpoenaed numerous mutual fund families.  Mutual fund families are actively reviewing the trading records of their fund managers and other employees to see if trading abuses have occurred.  Several fund managers and brokers have already resigned or been fired.

As noted earlier, Ibelieve the firms that allowed such prohibited transactions should be fined.   If their fund managers, executives or other employees also made such illegal trades, they should be fired. That appears to be happening.

Traditional Market Timing Gets A Bad Rap

If you are one of my clients, or if you have read this newsletter for long, you know that I am a big proponent of traditional market timing as a defensive investment strategy.  We are constantly searching the globe for money managers who have been successful at being in the markets during upward trends, but who also have been successful in getting out of the markets during part or most of the downward trends.

The important thing to note is that most of the money managers we recommend are NOT short-term, rapid-fire traders or day traders.  In fact, most of the money managers we recommend average only a relatively small number of trades in and out per year.  In strongly trending markets, these Advisors might not move out of a position for months at a time.

Additionally, traditional market timers manage less than 1% of the assets in mutual funds today.  Even if they were all short-term traders - which they are not -  they would have a negligible effect on the funds and their long-term shareholders.  Actually, most market timers who do short-term trading use the Rydex Funds or ProFunds or other funds like them that were specifically designed for, and cater to, short-term traders.

In short, traditional market timing has little or no impact on the mutual fund industry, but has significant potential benefits to investors who use this strategy. 

Yet you would not think that if you listened to the financial media in recent weeks.  Because of Eliot Spitzer’s poor choice of words, the media has elected to use the term “market timing” to describe the rapid-fire, short-term trading abuses that are now gaining widespread attention.

Why The Bad Rap Continues

The truth is that Spitzer gave the mutual fund industry a wonderful present.  When he called the rapid-fire, short-term trades “market timing,” he opened the door for a new attack on market timing as a legitimate investment strategy.  Why?  Because the financial press and the mutual fund companies want the public to take a dim view of market timing.  For years, the Wall Street mantra has been “buy-and-hold.”   They want you to put your money in their mutual funds and never sell.   This is why they have jumped on  Spitzer’s characterization of illegal trading as “market timing.”  They are all too happy to have the public believe that traditional market timing is a bad thing.

Buy-and-hold means that you will enjoy the times when the markets are rising.  But you will also lose money when the markets go down.  The S&P 500 plunged over 44% in the 2000-2002 bear market.  Many equity mutual funds lost that much or even more during that same period. 

The worst part is, all this attention to market timing has diverted the financial media from the illegal activities engaged in by mutual fund insiders and large shareholders to whom they gave special privileges.  As one market timing trade association (SAAFTI) member so eloquently put it, "Thus, the witch hunt that the funds are on against 'timing’ is actually a clever ploy to take the heat off the funds doing the illegal activity.”

Advisors who practice traditional market timing have NOT been implicated in ANY of the fund investigations to-date, and I do not expect them to be in the future. Clients and readers of this newsletter know the difference between the latest trading scandals and traditional market timing as practiced by our professional Advisors.  Unfortunately, many other investors don’t know the difference, and they will now probably never consider market timing, despite its potential benefits.

Fund Industry Proposes Changes

In a classic show of “the fox minding the henhouse,” the Investment Company Institute (ICI), a trade association of mutual fund companies, has proposed changes to the mutual fund industry with the goal of avoiding future abuses.  In its report, the ICI asked the SEC to erect three “tough roadblocks” to prevent future scandals.  Below, I will list the ICI's recommendations, and my reaction to each of them:

1.  Set a redemption fee of at least 2% on sales within a minimum of five (5) days of purchase.

The mutual fund industry has rarely met a fee it didn’t like!  This proposal by the ICI would go far beyond current SEC policy of allowing a fund to charge a fee by making it mandatory.  Mutual fund families that welcome frequent trading such as Rydex and ProFunds would obviously seek exemption from this requirement if it is adopted.

The most important part may not be the requirement to charge such fees, but the language - “at least” 2% and “minimum” five days.  Currently, the SEC allows funds to charge up to a maximum of 2% for early redemption, but the ICI proposal would make this the minimum fee you would pay.  Theoretically, funds could charge much higher fees for early redemption if they wanted to and/or require longer holding periods. John Bogle (formerly of Vanguard Funds) has proposed a mandatory 30-day holding period for all funds, which could be enacted if the ICI’s proposals are accepted.

I happen to think this whole idea is ridiculous!   First of all, one of the most attractive features of mutual funds is that they are highly liquid.  In most cases, investors may redeem on any given day they choose unless they invest in a fund that charges the optional early redemption fees.  However, investors have always had the option to go with a fund that doesn’t charge such fees.  If the ICI’s proposals are enacted, investors would have little or no choice as to the applicability of redemption fees.

Another problem I see with this approach is that it is widely known that investors rarely (if ever) read prospectuses.  If these early redemption fees go into place, there will undoubtedly be investors who sell prior to the required holding period - and be charged the fee - without even knowing it existed.  Whether or not the prospectus is read, investors who have sudden emergencies or other needs for money invested in funds may run afoul of these new redemption fees.

Ironically, the mutual fund families generally know who their short-term traders are, especially the larger ones.  They have software that identifies frequent traders.  If they don’t want such investors, they can just kick them out!  In fact, this happens fairly frequently already, so the funds don’t need these additional fees.  The ICI proposal amounts to nothing more than a smoke screen for an industry scheme to subject investors to longer “lock-up” periods.

Hopefully, these new fees, if they are implemented, will actually backfire on the fund families.  Investors may shun these funds and existing shareholders may choose to move elsewhere.  Time will tell.

2. Require all orders to be at the funds by the close of the market (4:00 PM Eastern time).

While most investors don’t know it, many mutual fund trades are not received by fund companies until many hours after the market closes.  However, the current rule is that fund trades must be entered either at the fund or with an intermediary (401(k) plan or mutual fund supermarket) by the market’s close.  These intermediaries can then process the orders and get them to the fund at a later time.

The ICI proposal would require all orders to be at the funds by the market's close.  In turn, this would require intermediaries to have much earlier cut-off times to be able to make the 4:00 PM Eastern time deadline.  While this doesn't sound like much of a problem, it works out to be a major disadvantage to those using intermediaries.

For example, many 401(k) participants like to sell one fund and buy another in the same day.  To do so, however, requires that the end-of-day price be known on both funds before the buy/sell can be executed.  Currently, this is possible because the orders can be forwarded to the fund companies after the close of business and shares have been priced.  The change proposed by the ICI would virtually eliminate the ability to buy and sell on the same day, and could potentially place a 12-hour delay on 401(k) trade execution.  Therefore, investors who are on the West Coast, or those who go through mutual fund supermarkets like Schwab, Fidelity, T.D. Waterhouse, etc., or who are 401(k) participants would be put at a big disadvantage if the ICI’s proposals are implemented.

Other mutual fund industry experts have criticized the ICI’s 4:00 PM trading deadline proposal, and have offered alternative ways to alleviate the problem.  One such proposal is for a national clearinghouse for processing all fund orders.  Current computer capabilities and encryption technology could be used to avoid any late-trading problems without affecting cut-off times for investors.

3. Set stricter standards for insider trading.  Duh!

Of all of the ICI proposals, this is the only one that addresses the actual root cause of the current scandals.  It was greed on the part of mutual fund industry insiders that allowed the improper trading to occur in the first place, and only changes that affect these insiders’ ability to engage in future illegal activities will prevent future occurrences.

While it is refreshing to hear that the mutual fund industry will “clean house,” many commentators (including me) are less than thrilled with the ICI proposal.  For example, the ICI says that one part of the new insider trading standards would be for all insider trades to be reported to the fund’s parent firm.   This is insufficient.  The SEC should go a step further and require public disclosure of insider trading, much as it does for corporate insiders.

The SEC is expected to propose new rules to deal with all of these issues by the end of November.   Until then, we’ll just have to wait and see how many more mutual fund firms are implicated in the scandal, and what effects this has on the market.

Where The Trading Scandal Is Headed

It is too early to know exactly how this trading scandal will play out.  It depends, of course, on how widespread and how onerous the trading abuses have been.  The Securities & Exchange Commission says that about half of the 80 largest mutual fund families have accommodated some form of abusive trading.  This is reportedly based on data supplied to the SEC by the fund companies.

I can see two possible scenarios developing as the investigation continues.  One is a fairly benign scenario, and the other is a chaotic scenario with major negative implications for the fund industry and, ultimately, the markets as well.

Let’s take the fairly benign scenario first.  The pattern that we are seeing so far is that most (not all) of this illegal late trading and prohibited rapid-fire, short-term trading occurred a few years ago.  It also appears that most fund families were making efforts to stop it before Eliot Spitzer blew the lid open on September 3.  Nevertheless, in the short-term, the ongoing investigations will generate more negative press for mutual funds and unfortunately, for traditional market timing.  There will be more announcements of fines and fund manager resignations or terminations.  This will drag on for several more months.

Yet if the overriding conclusions are that most of this abusive trading occurred a while back, and that the fund families have cleaned up their act, we may not see a mass exodus from mutual funds.  You can be assured that the $7 trillion mutual fund industry will mount a huge media effort to convince the public that they have cleaned house and will forever more play by the rules.  If this is the scenario that plays out, it is possible that the fund industry can ward off public disillusion and massive redemptions.

The Chaotic Scenario

In this scenario, we find that the trading abuses have been much more widespread and onerous than is currently expected, and that they continued until just recently when regulators got involved.  If this were true, then the losses to long-term investors in the funds involved would be much greater.  This would create a firestorm of media criticism.  In this scenario, the fines levied against many of the fund families, individual fund managers and other employees who were involved would be much larger and much more high profile.

In the weeks following Eliot Spitzer’s initial announcement of alleged trading abuses at Bank of America’s Nations Funds, Banc One, Janus and Strong, some of the mutual fund rating services dropped their ratings.  We saw investors pull money out of those funds.  While the redemptions were not small, they were not so large as to seriously disrupt or threaten the continued operation of those funds.

But let’s say that the news over the next few months is worse than expected.  That raises serious questions.  For example, will investors flee these funds in droves?  If yes, where will they go?  Will they all go to the perceived “safe” funds?  Does this mean that the number of mutual fund families shrinks dramatically?  And the remaining families balloon in size?  How chaotic would that be?

Will investors fleeing mutual funds simply move to the sidelines, vowing never to invest again in light of the corporate scandals now followed by the greed of mutual fund companies?  Or will they seek alternative investments?  If investors do flee to the sidelines in droves, that will mean significant selling pressure in the markets, as fund families have to dump stocks to meet redemptions.  This could usher in a new bear market.

The Other Market Threat:
Another Major Terrorist Attack

When we are talking about what could derail the current bull market in equities, we cannot ignore the threat of more terrorist attacks on our soil.  All of my geopolitical sources agree that one of the main goals of al Qaeda and other terrorist groups is to make something bad happen that will unseat President Bush next November.  This would be the crowning moment for the terrorists if they could defeat the Commander-In-Chief of the War On Terror.

My sources believe that the greatest threat for another serious terrorist attack on American soil lies in the next 6-9 months, so as to have the maximum impact on the 2004 presidential elections.

As you know, my outlook for the US economy has been very positive for the last year, and that has proven to be the correct forecast. I have also been positive on the stock markets this year, and that has also proven correct.  With the latest scorching economic news (GDP up 7.2% in 3Q), the economy would appear to be on a sound growth path for the next year, and stocks will likely continue at least mildly higher as well.

Yet all that could change if there is another serious terrorist attack in the US.  Like Stratfor, none of my other sources have any specific intelligence regarding another attack.  Yet if the terrorists are intent on driving Bush out of office, they probably need to strike in the next six months or so.

On the bright side, there has not been a serious terrorist attack on US soil since 9/11.  Clearly, the increased security measures we have adopted since 9/11 have lessened the likelihood of another major attack, but they have not eliminated the threat.

As investors, we should not pull all or most of our money out of the markets just because another terrorist attack “might” happen.  Yet we should also be ever mindful that another serious terrorist attack in the US could have major negative implications on the economy and the equity markets, just as it did after 9/11.

Conclusions

As more mutual funds are cited for illegal late trading and/or allowing short-term, rapid-fire trading when their prospectuses prohibit it, you can expect to see more negative press regarding market timing.  Keep in mind that the mutual fund industry and the financial media want you to think negatively about true market timing, since they make more money if everyone would simply buy-and-hold.

Also, keep in mind that the rapid-fire trading they are referring to is not what traditional market timing is all about.  Not all traditional market timers trade frequently.  Some make only a few trades each year.  Most professional market timers who do trade frequently use the Rydex Funds or ProFunds which were specifically designed for frequent trading.

As noted above, I believe that all of the fund families who have allowed illegal trading should be fined and disciplined.  Likewise, those who have allowed and/or encouraged short-term, rapid-fire trading - in violation of their prospectuses - should also be disciplined.  That appears to be happening.

I do not believe the answer is for fund families to impose new early redemption fees to curb short-term trading of their funds.  If they don't want it, they should simply kick out the short-term traders.  Most of them have already gone to Rydex or ProFunds anyway.

Long-term, the current scandal will turn out to have been a good thing, in my opinion.  Fund families will get their act together.  Unethical fund managers will be removed.  Shareholders will get fair treatment.  Things should get back to normal in a few months.

On the other hand, if the trading abuses are more widespread than currently expected, the fallout in mutual funds could be dramatic.  Investors could flee in droves from the fund families cited for abuses.  This could spark a new bear market in equities, although I don’t believe this is the most likely scenario, at least at this point.

Don’t Give Up On Mutual Funds

And one last point.  This article above comes across pretty negative regarding mutual funds.  But for the record, I am still a huge fan of mutual funds.  While some are being fined and/or disciplined, these problems can, and very likely will, be fixed. 

You know the old saying, “Don't throw the baby out with the bath water.”   In regard to mutual funds, this means that you shouldn’t give up on this very beneficial form of investing just because there are a few bad apples in the bunch. 

When all the investigations are done, I expect that the trading abuses at most mutual funds were relatively minor - in the context of a $7 trillion industry.  Those who violated the rules will be disciplined accordingly, in my opinion.  The short-term trading abuses will stop and probably have already.

Mutual funds are still the hands-down best choice for smaller investors, allowing a level of diversification and professional management they can't achieve on their own.

Whether you are a buy-and-hold investor, or a market timing investor - or both, as I am - mutual funds (carefully selected, of course) remain an excellent investment vehicle. 

I have struggled for years to combat the confusion between myself and the “other” Gary Halbert, one Gary “C.” Halbert, who also runs in certain investment circles.  I’m Gary “D.” Halbert and am NO relation to him.  I have never even met him.  If you search Google  (the largest Internet search engine) for “Gary Halbert,” you will not find a link to me until you get about 40-DEEP into the Gary Halbert links; the previous links are all about Gary C. Halbert.  [Warning: should you go to Gary C. Halbert's website, which I do not recommend, be prepared to see some profanity.]

Well, the Securities & Exchange Commission has recently initiated litigation against Gary C. Halbert and his son, Bond Halbert, for “possible violations of the federal securities laws” related to a stock trading system they have been promoting.  Here is the SEC press release on Tuesday, September 23:

QUOTE: “U.S. Securities and Exchange Commission. Litigation Release No. 18359 / September 23, 2003...

SEC Files Subpoena Enforcement Action against Gary C. Halbert, Cherrywood Publishing, Inc. and Others...

The Securities and Exchange Commission today filed an action in Massachusetts federal court to enforce investigative subpoenas against Gary C. Halbert, Bond Halbert, Cherrywood Publishing, Inc. ("Cherrywood"), and John Doe (a/k/a Cherrywood's Keeper of Records"). The Commission alleges in its application filed with the court that Gary C. Halbert, Bond Halbert, Cherrywood, and Cherrywood's Keeper of Records failed to comply with administrative subpoenas requiring them to produce documents and testify in connection with an investigation to determine whether they and others may have violated the antifraud provisions of the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940. In its application and supporting papers, the Commission alleges that, on August 12, 2003, the Commission issued a formal order of private investigation entitled In the Matter of Cherrywood Publishing, Inc., File No. B-01967 ("Formal Order"). The Formal Order directed the Commission staff to undertake a private investigation to determine if there were violations of the federal securities laws. According to the Commission's court papers, the Commission staff is investigating possible material false statements concerning a stock trading system made by or on behalf of Gary C. Halbert and Cherrywood in newspaper advertisements that appeared in USA Today and on a website purportedly operated by Gary C. Halbert. According to the application, the Commission staff issued subpoenas to Gary C. Halbert, Bond Halbert, Cherrywood, and Cherrywood's Keeper of Records on August 12, 2003 and issued a second subpoena to Bond Halbert on August 20, 2003, requiring them to produce documents and testify concerning matters relevant to the investigation. As of September 23, 2003, the Commission alleges that the parties have not produced the responsive documents and have not testified as compelled by the subpoenas." END QUOTE.

If you want to read more about the SEC’s investigation into Gary C. Halbert, go to the link below on the SEC’s website.  It is interesting reading.  In it you will find that Mr. Halbert has apparently left the country.

www.sec.gov/litigation/litreleases/app18359.htm

In closing, let me tell you that the latest regulatory problems for the “other” Gary Halbert are a relief to me.  Obviously, I don’t know if Gary C. Halbert is guilty of any securities violations or not.  But I can tell you that due to his marketing campaigns, people have confused him with me, and it has always been frustrating for me.  Whatever happens, it will not be a disappointment for me if he is out of the investment business for good!