In its second report on 3Q GDP, the Commerce Department reported that the economy rose at a blistering annual rate of 8.2%, up from its advance estimate of 7.2%.   Consumer spending was stronger than expected in the 3Q.  Meanwhile, the long suffering manufacturing sector has improved significantly.  Likewise, unemployment data has improved over the last two months.  While a growth rate of 8+% is not sustainable, the economy should continue to surprise on the upside.

With the economy surging, most analysts expect the Fed to begin raising interest rates any day now.  However, the Fed says it remains committed to keeping interest rates low.  There are two reasons for this.  First, the Fed realizes that the US economy came dangerously close to a deflationary recession, and as a result they want to maintain a very stimulative interest rate environment.  Second, despite the very low level of short-term interest rates, monetary growth has actually declined over the last year.  The Fed will eventually begin to raise rates, but probably not for a few more months.

The Bank Credit Analyst remains optimistic about the economy and equity prices.  They expect the economy to grow at a rate of around 4-5% over the next year, and they believe the stock markets will continue to be the beneficiaries of a strong economy and continued low interest rates.  I will review their latest thinking in this issue.

The major equity indexes moved sideways to lower in November, despite the best economic news in years.  This has many investors asking why.  Actually, the markets had already anticipated this news, and the recent price action appears to be a period of consolidation before moving higher.  Treasuries and high-grade corporate bonds remain in the doldrums and are likely to stay that way.  Despite that, Capital Management Group, which trades in high-yield bonds, continues to have an outstanding year.  Gold has finally broken out above $400 resistance for the first time since early 1996 and appears to be headed even higher.  And, we look at gold this month.

Finally, you may (or may not) be happy to know that I am now a clean-shaven man after 25 years with hair on my face. See page8.

Firing On All Cylinders

Economic reports in November were the strongest in many years.  The economy is now firing on all cylinders, and job growth is poised to improve significantly over the next 6-12 months.  As noted on page one, the Commerce Department reported that the economy expanded at an annual rate of 8.2% in the 3Q, up from 7.2% in its previous report and 3.3% in the 2Q.  Best of all, the latest GDP report showed a significant increase in business investment spending in the 3Q, up 18% for the quarter.

Perhaps second best of all, the manufacturing sector expanded at the fastest rate in almost 20 years in November.  The Institute for Supply Management’s  manufacturing index jumped to 62.8 in November, up from 57 in October.  This marked the fifth consecutive monthly rise in factory output.

Corporate profits soared 30% above yearago levels in the 3Q.  This was the largest year-over-year gain in corporate profits in 19 years.  Companies have been reluctant to hire new workers over the last year, but with the latest surge in profits and continuing strong demand, the unemployment rate should continue to fall in the months ahead.

Consumer confidence also rose in November.  The Conference Board reported that its Consumer Confidence Index jumped to 91.7 in November, up from 81.7 in October.  Retailers reported that department store sales on the Friday after Thanksgiving (the biggest shopping day of the year) rose 5.4% over the same day last year.

The gloom-and-doom crowd, while never silenced, has toned-down its always pessimistic rhetoric about the economy.  Ditto for the Democratic presidential candidates.  Interesting, isn’t it, how these groups never admit they were wrong, but just go silent and move on to other issues?  Fortunately, my best sources have been mostly dead-on regarding the economic turnaround in the last year or so. 

How Long Can It Last?

Now the question is, how long can the good economic news last?  Clearly, the economy cannot continue to grow at an annual rate of 8+%.  Most economists now expect the growth rate to cool to a 4-5% rate in the 4Q and slightly below that in the first half of 2004.  Those expectations would seem reasonable in light of the latest 8.2% report.

Yet there are also many respectable analysts who believe that this recovery could well fizzle after the first half of next year.  Most in this camp argue that the excesses built up in the ‘90s boom were not corrected by the mild recession of 2000-2001.  Likewise, they point to record consumer and federal debt and conclude that these problems will spell an early end to this recovery.  These, of course, are all serious and valid points that don’t bode well for the future, but the question is when?

While the storm clouds are clearly on the horizon, this economy may yet continue to surprise on the upside for at least two reasons.  First, US productivity rates have advanced by record proportions over the last several years, thanks in part to the recession.  While this contributed to the rise in the unemployment rate, the surge in productivity is bullish for the US economy in the long run.  Second, those predicting an early end to the recovery fail, in my opinion, to recognize the powerful stimulus of the near historical low interest rates we have enjoyed over the last few years.

Finally, while consumer debt levels are at record highs, there are not indications that consumers are about to fall off a cliff in terms of spending.  Actually, consumer spending is expected to increase by 4-5% in 2004.  As noted above, business investment spending has finally kicked in, and this will cushion the economy even if consumers slow down their spending.

The bottom line is that this recovery should continue for another year, and perhaps even longer, unless there are some major negative surprises to come.

As you know, I have been a continuous subscriber to BCA for over 25 years.  While not perfect, BCA continues to be the most accurate forecaster of significant  economic turning points and major financial market trends that I have ever read.  This month, I will summarize and quote from BCA’s December issue.   I found their analysis of what the Federal Reserve is, and has been, thinking particularly interesting.

“The foundations under the U.S. economy are getting stronger. The corporate sector is emerging from its severe retrenchment, thereby reducing the economy’s dependence on continued strong growth in consumer spending. With demand becoming more balanced, there is less need for major policy stimulus, and the odds are good that the economy will continue to deliver positive surprises in the coming year.

The Federal Reserve is taking nothing on trust. The Fed’s base case is that the economy will grow at a decent pace next year, but it does not have a huge degree of confidence in this forecast. The Fed has thus made it clear that it will retreat only slowly from its current highly stimulative stance.

The maintenance of abnormally low interest rates will substantially boost the prospect of solid economic growth, and will foster continued risk-taking by investors. Equities should keep outpacing both bonds and cash in 2004, even though the absolute gains from stocks will likely fall short of those achieved this year...

It is sometimes argued that the Fed has seriously erred by easing policy so aggressively during the past couple of years. The sharp drop in interest rates encouraged consumers to take on more leverage rather than retrench, and also stopped the equity bubble from fully deflating.

There is no doubt that keeping the fed funds rate at 1% has created financial distortions and has fueled speculation. However, the Fed has explicitly wanted to encourage more risk-taking, to counter the retrenchment that normally occurs in the wake of a burst assetbubble. The Fed was not able to prevent a deep cutback in corporate sector spending, which made it all the more important to prop up consumers.

After the bubble burst, the corporate sector suffered the worst downturn in profits since the 1930s. If the Fed had not taken aggressive action to boost housing and consumer spending, the squeeze on the corporate sector would have been even more severe, which would have fed back into even weaker employment. The end result could have been a self-feeding downward spiral of economic activity and asset prices, presumably triggering a full-fledged debt deflation...

The Fed’s policy has not been costless. By encouraging the consumer sector to take on more leverage rather than rebuild savings, the Fed has raised the stakes for the next downturn. The downside risks in the next recession may be much greater than they would otherwise have been, because of increased debt levels. However, the Fed decided that it was worth trading almost certain disaster in the recent cycle for a potential threat at some point in the future.

The same argument can be made for fiscal policy. The Administration has been responsible for turning a large structural fiscal surplus into a large deficit, with possible serious long-term consequences. Nonetheless, tax cuts played an important role in supporting the consumer at a time when the corporate sector was engaged in a vicious retrenchment...

One might reasonably have expected a very deep recession given the bursting of one of the greatest asset bubbles in history, the shock of September 2001, the rash of corporate scandals, and high energy prices. The fact that the U.S. suffered the mildest downturn on record is testimony to the power of the massive stimulus thrown at the economy.

Even so, the economy skirted dangerously close to deflation, and the Fed is not convinced that the danger period has ended... The Fed has lost confidence in its own and everyone else’s economic forecasts. The Fed’s economic models did not work very well during the past couple of years.”

What the editors are saying here is that the economy’s near-miss with deflation during the recession basically scared the pants off Alan Greenspan and the Fed governors.  In response, they overreacted and will probably not breathe a sigh of relief until they see the inflation rate begin to inch higher.   In doing so, they not only managed to avert deflation but they significantly softened the recession, and now we find ourselves in a roaring economy.  Of course, as BCA pointed out, this has resulted in higher debt levels and much greater risks whenever the next recession comes along.

When Will Rates Go Up?

This, then, brings us to the question, when will the Fed begin to raise interest rates again?  The Fed knows that a 1% Fed funds rate is too low and will eventually need to be raised to between 4% and 5%, a level that is consistent with potential GDP growth.  The Fed also knows that the longer rates stay at 1%, the more problematic the adjustment will be for the markets.  They likewise know that leverage and debt levels will continue to build as long as rates remain extremely low.  Nevertheless, these are regarded as minor problems compared to those associated with raising rates too soon.  The bottom line is that the Fed feels under no pressure to change its stance just yet.

Following the last FOMC meeting, Greenspan stated that it is the Fed’s intention to hold rates at these low levels for a “considerable period.”  As usual, no one knows what he means by that.  The latest strong economic news has led many to suggest that the Fed may begin raising rates any day now.  However, BCA    believes that the Fed will insist on seeing “sustained strength in the labor market (several months of at least 150,000 job gains),” and clearer signs that the threat of deflation has passed.

Thus, BCA makes the case that any such rate increases won’t begin until next spring, or maybe even the middle of next year.  And they believe that the Fed will move slowly when they do start to move.

BCA believes that the next move by the Fed will be the dropping of the “considerable period” (before rates are increased) language, and thus leave it open as to when rates will be increased.  That could possibly occur as soon as the December FOMC meeting.  I don’t believe that will have any significant negative effect on the markets, since many analysts are thinking that the latest strong economic news could lead to a small rate increase very soon.

Will Rate Hikes Hurt Stocks?

As discussed above, it is BCA’s position that the rate hikes won’t begin until next year, specifically in the 2Q at the earliest, and the increases will come slowly and in small increments.  Unless rates have to be hiked in a more rapid manner, BCA believes stocks will continue to do relatively well.  They believe that stocks will be even higher in a year than they are today.  In case you are wondering, here is BCA’s argument for holding above-average positions in stocks and/or mutual funds:

“The equity market has marked time in the past month, despite a strong showing from the economy and corporate earnings. The market had been overbought following earlier gains, and geopolitical concerns and mutual fund scandals have weighed on investor sentiment. Equity prices may have also been held back by a desire to lock in gains before the end of the year. Nevertheless, the cyclical bull market remains intact, with the major indexes holding above their rising 200-day moving averages.

The case for equity prices rests on the following:

[1] The negligible level of short-term interest rates provides a powerful inducement to seek higher returns in stocks. This is especially true given the huge stockpile of cash sitting in retail money market funds and savings deposits. Investors should become more comfortable taking on extra risk as their confidence in the economy improves.

[2] Valuations are reasonable with the S&P 500 trading at around 17 times forward operating earnings. With earnings expected to rise by at least 10% next year, equity prices will rise even if multiples stay constant.

The bears have been frustrated by the fact that the market never became compellingly cheap as would have been expected following the bursting of the bubble. In past bear markets, the price/earnings ratio (based on forward operating earnings) dropped to 12 or less. This time, it never fell below 15. However, by slashing interest rates aggressively, the Fed was deliberately trying to prevent a complete market washout, and its policy was successful. The market has long since passed the maximum danger point, and a major relapse would only occur in the context of a major event that shocked confidence and triggered a renewed slump in the economy. The probability and timing of such an event is impossible to predict.

This does not mean that the market will not suffer periodic setbacks. For example, the optimistic level of investor sentiment warns that the market is still a bit overextended. However, this can be unwound with a sideways move rather than a large drop in prices.

On balance, we continue to recommend above-average weightings in equities. The gains during the coming year seem likely to fall short of those achieved in 2003, but the potential exists for the market to exceed expectations once again.”

BCA’s views on stock market returns over the next year are consistent with those of numerous other respected analysts.  Specifically, that stocks will continue to rise in 2004, but not at the pace we enjoyed this year.  Most analysts I read (other than the gloom-and-doom crowd) believe that the broad stock markets will rise by 8-10-12% next year.

Doing Better Than That

Let’s say you accept the forecast for stocks rising modestly next year, but you want to do better.   You know that a buy-and-hold strategy is generally only going to make you what the market makes.  There are other strategies that hold out the potential to do better than the market averages.  One such strategy is picking individual stocks that you believe will perform better than the market overall.  Many people do this, and there are even tax benefits (long-term capital gains) if you hold your stocks a year or longer.

The problem is, most of us are not good at picking the top performing stocks, certainly not those that will beat the market averages for a year or longer.  Making matters worse, today’s top performing stocks frequently go out of favor and underperform the market from time to time.

Another popular strategy to beat the market averages is called “sector rotation.”   In this strategy, you attempt to identify the hot sectors within the market and invest accordingly.  This year, for example, it paid handsomely to be in tech stocks once again.  The Nasdaq Index is up 47% whereas the S&P500 is up only 21% as this is written.  A sector trader that bought the Nasdaq stocks (or a good Nasdaq-type mutual fund) would have more than doubled the broad market rate of return so far this year.

But how many people do you know who shifted into tech stocks early this year and made those kinds of returns?  Not many (or any), I suspect.  Sector rotation is a viable strategy, but like picking the hottest individual stocks, most of us are not good at knowing which sectors will be hot and when to get in and out.

Niemann Capital Management

As I have written often, Niemann Capital Management is one of our recommended Advisors that uses the sector rotation as a part of its strategy.  I included detailed information about Niemann with the October issue of F&T.  If you look back at that information, you will see that Niemann, with its sector rotation strategy, managed to significantly outperform the major market averages this year.  They have systems, among others, for identifying the best sectors.  Unlike most of us, they moved back into tech stocks earlier this year and have posted outstanding results.  Past performance is not necessarily indicative of future results.

If BCA’s (and others’) forecasts for 2004 are correct - that the market averages will rise by only 8-10-12% next year - this could once again be an environment where a sector rotation strategy will outperform the market averages.  That remains to be seen, of course, but this is where Iwant to have a chunk of my equity money in the coming year.  As a result, I am going to increase my allocation to Niemann before the end of the year.  If you haven’t considered Niemann to this point, Isuggest that you do now.

Time To Buy Gold?

With the recent breakout over $400 per ounce, gold has become an even hotter topic among  investors.  The last time gold was above $400 was February 1996.  If gold remains above $400, there could be considerable upside potential due, among other things, to short covering.  Other reasons include the unstable geopolitical situation, the recovery in the economy with the likelihood that inflation will rise and improving supply/demand fundamentals.   Due to the long period of depressed prices, exploration and production have slowed and mining companies are working to catch up.

Another big factor helping gold along is the decline in the US dollar, which is expected to continue to fall.   Gold does not always react to supply and demand forces the same way that other commodities do because gold has a hybrid nature.  While it is a commodity used by many industries, it is also a currency maintained in vast reserves by many countries and as a store of wealth by individual investors.  As a result, the price of gold is often dictated more by its relative value to currencies rather than on a strict supply/demand basis.  So, the falling dollar is a big plus for gold.

Another potentially explosive factor is the gold “leasing” programs that have been popular over the last decade or longer.  For years, central banks have been leasing gold to so-called “bullion banks” that, in turn, sold the gold to investors.  The lease contracts, which are typically rolled over year after year, call for repayment in physical gold bullion.  The assumption in these arrangements is that gold prices will remain in a relatively narrow price range.

At some point, however, especially if the price of gold continues to rise, the central banks might elect not to roll over the lease contracts.  I don’t know at what price the central banks would feel compelled to end the leases, but if the bullion banks have to buy large quantities on the open market, the price of gold could go through the roof.  The central banks, of course, don’t want to see that happen, so I would not bet on this happening.  But I would not rule it out either.

Reasons To Be Cautious

Just as there are reasons to be bullish about the price of gold, there are some valid reasons to be cautious about running headlong into a major gold investment at this point in time.  Gold bottomed in 1999 at $252/oz., so it has already risen over 60% from the low.  So, gold is not cheap at $400+ per ounce.  Most of the bullish factors are already priced in, not that new bullish factors won’t develop, as discussed above.

Many who are convinced that gold will continue to move higher believe the US dollar is headed for a major collapse.  Excuse me, but the economy is booming and as a result, I don't believe the dollar is headed for a collapse.  Also remember that 2004 is an election year, and all the stops will be pulled out to make sure the economic recovery continues and the dollar doesn't collapse.

As I have written before, I have concerns regarding the various methods of investing in gold, as they relate to the average investor.  The purchase of physical gold in its various forms (coins, bullion bars, etc.) involves not only significant bid/ask price spreads, but also the additional expense of storage and insurance (versus the risk of keeping it at home and hoping you are not robbed.) 

An example of the bid/ask spread can be found by going to www.kitco.com.  On the day this is written, the asking price for a one-ounce American Eagle gold coin is just over $423, while the bid price to anyone wanting to sell gold Eagles to Kitco is $395.  That’s a lot of ground to make up.  Gold bars have smaller bid/ask spreads, but are still significant and there is still the matter of storage to be dealt with.

I have recently seen direct-mail and e-mail ads offering a “secret currency” investment that was “outlawed for 41 years,” but is now graciously offered to you.  This investment is nothing more than numismatic gold and silver coins, which have a value higher than the spot price of the metal based on rarity and condition of the coins.  This investment not only has the normal problems associated with physical gold, but adds the requirement that you be able to identify and evaluate the numismatic qualities that provide the extra value.  My advice is to just say “NO” to these investments unless you are an expert in this field.

Gold stocks and precious metals mutual funds are another way to participate.  While the price of gold has increased over 60%, many gold stocks and mutual funds have increased 100% or even more over the same time period.  This brings me to another reason for caution.  These stocks have been pushed up in price, usually based on an assumption of even higher gold prices.  Thus, a higher gold price is built into these stocks and mutual funds than the current price, and many times by more than the assets and future production of the various companies can justify. 

That brings up another point.  Historically, when these mining stocks soar higher as they have, they tend to fall off a cliff when they peak out .  With gold up over 60% and many of these stocks up over 100%, there will almost certainly be some very nasty corrections which could occur at any time.

Gold futures and options are another way to try to get in on the precious metals action.  However, these investments are highly leveraged and contain a very high degree of risk.  Thus, they are generally only appropriate for those who are experienced in trading such contracts.  Remember, most people lose money trading futures, and especially options, on their own.

When I have written about gold before, I have had readers ask why I didn’t include a new opportunity called “E-Gold.”  The reason I didn’t is because this is fairly new and appears to be more geared toward using gold as a method to conduct business on the Internet than as an investment.  The E-Gold website describes it as an “electronic currency” backed by physical gold held in storage, thus making international Internet trade more feasible.  While it sounds good, I’m going to reserve judgment for a while. 

Conclusions

Gold’s breakout above $400 is a significant positive development for gold.  The trend is up, and it will not surprise me if gold continues to move at least moderately higher.  As discussed above, there are some developments which could be extremely bullish for gold, but keep in mind that this possibility has been a fact that has helped drive gold up significantly already.

The question most investors have been asking me recently is, “Should I buy gold now?”   While I do expect gold to continue at least moderately higher, buying now - after the price is up 60% in bullion and 100% in some gold mutual funds - means taking a LOT of risk.  I personally would not buy gold today.  On the other hand, if you bought gold earlier at lower prices, I would suggest holding onto it to see if some of the developments discussed above come into play.

New Gold ETF In The Works

The SEC is currently considering approval of a new  Electronically Traded Fund (ETF) that will be based on the price of gold.  If this new fund is approved, it will be the first vehicle to allow investors to trade in bullion in a fund concept.  In my opinion, this ETF could well prove to be a better way to invest in gold, since it will be tied to the actual price of gold and backed by physical bullion (as I understand it)  If it works as suggested, it will solve the storage dilemma related to physical gold.

In addition, this ETF will be traded on the stock exchange just like any other public security, so buying and selling will not be nearly as onerous as physical purchases of gold bullion or coins.

Of course, we need to learn more about this new ETF.  If it is approved by the SEC, you will want to read the prospectus VERYCLOSELY as it is a brand new investment vehicle.  I will write more about this new gold ETF if and when it is approved by the SEC.

Finally, please beware of “predictions” on how high gold is going.  Now that the price is above $400, I hear predictions, that sound like promises, that gold is going to $500, $600, $800 or $1000 or more.  Just remember that NOONE KNOWS where the price of gold is going!  And if for some reason, gold slumps back under $400, there could be a nasty selloff.

Available In January

Most of our clients have multiple accounts with us.  Some have accounts with the mutual fund Advisors we recommend as well as futures funds and other  types of accounts.  Because these accounts are typically held at various custodians, we have never been able to produce a “consolidated” statement showing all accounts individually, as well as the total amount you have invested with us.

For the last year, I have had our computer/software department working on developing a system whereby we can provide you consolidated account statements.  I am happy to report that we are in the final testing phase of this project, and we expect to be able to provide consolidated statements beginning in January.

We will offer the consolidated account statements on a quarterly basis at your request.  The statements will show the beginning balance and ending balance  for each account during the quarter - plus any additions or withdrawals.  The statement will also show the total amount you have invested with us in all accounts combined.  I will let you know when these statements are ready to go, and you can request them if you so desire.

The Clean-Shaven One

For the last 25 years, I have had hair on my face in one form or another.  When I was in my late 20s and 30s, I liked the beard because it made me look older.  But then in my 40s, the sides of my beard started graying, so I went to the goutee look.  In recent years (I’m now 51), even that started to gray a little.  So, a couple of months ago, I shaved it all off (without telling anyone in advance). Ican tell you it was quite the surprise!  Neither Debi nor the kids had ever seen me without hair on my face.  The before and after photos are below.  Iwill tell you that I miss the hair on my face, and I’m still getting used to the full shaving routine.  

I haven’t talked about my family in a while, so here’s an update.  My wife Debi still works at ProFutures, keeping us all in line.  My son Tyler is now 13 and is still a sports fanatic, playing something year-round.  My daughter Jordyn is 11 and she, too, is very much into sports.  They both go to a private Christian school in our area, and I continue to be very active in coaching them in sports.  We still live on Lake Travis.

In closing, let me thank you for your business and wish you joyous and memorable HAPPYHOLIDAYS!!