The government reported that the economy grew at an annual rate of 4.1% in the 4Q of 2003, up slightly from its previous estimate.  Most economists expect growth to be in the 4-5% range for all of 2004.  Economic reports released over the last month were positive on balance.  The manufacturing sector continues to rebound strongly, which suggests that the employment picture will continue to brighten in the months ahead.  On the other hand, consumer confidence fell in the latest reports, but I believe this is largely due to the negative rhetoric from the Democratic presidential race.

The Bank Credit Analyst remains very optimistic about the economy for 2004 and even beyond, barring any major negative surprises.  As discussed last month, BCA has expected the Fed to raise interest rates this year.  However, in their latest March issue, the BCA editors predict that the Fed probably will NOT have to raise rates this year.  Certainly not before the election, if at all this year.  I will explain BCA’s latest change in their forecast on pages 3-4.

BCA continues to forecast higher equity prices this year.  Like most analysts, BCA does not expect a repeat of 2003’s lofty returns; however, they do not rule out another “overshoot” in equity prices this year.   Their best guess is that equity prices will top out in late 2004, and they continue to recommend fully invested positions in stocks for the time being.  The editors continue to advise below average positions in Treasury bonds and other high-grade corporate bonds for reasons discussed on page 4.  Also, the BCA editors suggest that the US dollar may move into a generally sideways trading range for a few months prior to resuming the downtrend.

This month, I revisit the issue of the mutual fund scandals that first hit the news in late 2003.  As this is written, over 20 fund families are reportedly being investigated for trading abuses.  More importantly, Congress and  the SEC are rushing to pass new rules and regulations for the mutual fund industry.  And guess who’s in favor of these new laws?   The mutual fund industry!  Unfortunately, much of the proposed new legislation will result in higher fees and new restrictions on investors in mutual funds.  This is not good, and I will tell you why on pages 5-8 in this issue.

Economy Remains On A Solid Track

To hear the Democratic presidential wannabes tell it, the economy is in shambles.  But we know differently.  GDPgrowth in 2003 was the strongest in many years, spurred by tremendous gains in productivity, as I will discuss below.  Yet the great strides in productivity have meant that employers could delay adding new jobs.  Fortunately, that is beginning to change, and employment trends will improve in 2004.  Despite what desperate Democrats may say, this is hardly an economy that is in trouble!

The US economy expanded at an annual rate of 4.1% in the 4Q, so reported the Commerce Department last Friday.  The latest report was slightly better than average expectations of 4.0%.  The main reason the latest report was higher than expected was a significant increase in business investment spending.  Capital spending expanded sharply at an annual rate of 9.6% in the 4Q, up from the pre-report expectation of only 6.9%.

The better than expected rise in business spending reflects growing confidence among executives that the economy is on a sustainable growth path.   Higher capital spending also signals that hiring will continue to rise, and the unemployment rate should continue to fall in the months ahead

The Index of Leading Economic Indicators rose 0.5% in the latest report and has risen at a 5% annual rate since the low a year ago.  This is one of the main reasons most economists, the Fed and BCA expect the economy to grow by 4-5% in 2004.

The manufacturing sector continues to improve.  The Institute for Supply Management index rose in January for the ninth consecutive month.  Industrial production rose 0.8% in January.  And the purchasing managers index (NAPM) hit the highest level since September 2001 in February.  Meanwhile, the housing sector remains very strong.  Housing starts hit a 25-year high in 2003.  These indicators  and others point to continued improvement in the economy.

Likewise, these positive trends indicate continued improvement in the employment picture, especially in the manufacturing sector.  The unemployment rate has now fallen from its peak of 6.3% to 5.6%.  While the unemployment rate has been slow to fall due to great strides in productivity, expect to see a gradual acceleration in job creation during the rest of this year and probably into 2005.  Unemployment could fall to around 5% by the end of this year.

On the negative side, durable goods orders declined 1.8% in January, and retail sales fell 0.3%.  As noted above, consumer confidence fell somewhat sharply in the latest report, but it is important to note that the confidence survey is about opinions and is no doubt influenced by all the Democratic rhetoric about the economy.  This must be weighed against actual consumer spending which has continued to rise for the last several months.

There are those who point out that the 4.1% growth rate in the 4Q was only half the torrid pace of 8.2% set in the 3Q of last year.  But as I have pointed out often in the last several months, the 8.2% rate was an unusual occurrence which could not be sustained. 

The GDP Price Deflator and the Consumer Price Index rose 1.9% in the 12 months ended January.  This indicates that inflation is still well under control, even though the economy is in the second full year of recovery.  Normally, inflation would be on the rise by now.

These latest reports confirm the economy is now on a much more stable, non-inflationary track.  This is good news for interest rates as I will discuss below.

The question is, will the story of the improvement in the economy and the improving job creation outlook  be enough to propel George Bush to a second term in the White House, or will the Democrats be able to continue to distort the truth as they have done for months?  This remains to be seen.  So far, Bush and the Republicans seem to be losing the battle, despite the good economic reports over the last year.

BCA Remains Optimistic

In their March issue, the editors maintain that the economic recovery will continue all year and well into 2005, barring any major negative surprises.  Here are some excerpts from their latest issue:

“The economy is moving on to more solid foundations as the corporate sector takes on a bigger role in the expansion. Surveys of business activity by the Institute of Supply Management and the National Federation of Independent Business show a marked improvement in orders, hiring and general confidence.   This is consistent with the dramatic improvement in corporate profitability.

Companies have not yet fully abandoned their cautious mindset. There is still an entrenched focus on cost control that translates into a reluctance to both rebuild inventories and take on more fulltime staff. Nonetheless, the improving trend in leading indicators of employment and signs of increased supply bottlenecks suggest that companies are reaching the limits of their ability to meet growing demand with existing resources. Both employment and inventories are likely to rise in the months ahead, ensuring that the economy will continue to expand at a healthy pace.

A year ago, there was widespread skepticism about the economic outlook. The popular view was that the bursting of the equity bubble, together with a financially stretched consumer sector, would represent serious headwinds to growth. We took a more positive view on the grounds that the policy stimulus was unprecedented, and consumers were in better financial shape than generally believed.

Now, a bullish view on the economy has become more accepted for this year. The consensus forecast for GDP growth is 4.2% in the year to 2004 Q4, according to nearly 50 financial economists tracked by Blue Chip Indicators. Fed policymakers are even more bullish with a forecast range of 4½% to 5% for GDP growth.

It is reasonable to expect a slowdown in growth next year as the impact of policy stimulus wanes. However, short-term interest rates are still likely to be below their equilibrium rate through 2005, ensuring that growth holds at or above its trend rate of between 3% and 3½%. This would be consistent with continued growth in profits and a gradual rise in inflation.”

BCA Alters View - Maybe
No Interest Rate Hike In 2004

The editors of BCA have predicted for several months that the Fed will have to raise interest rates at least once this year due to the strong economy and the need to keep inflation in check.  However, in their latest March issue, the editors suggest that interest rates may not be increased until at least after the election and maybe not until next year.  Here’s why.

As noted above, the economy slowed to a non-inflationary rate of 4.1% in the 4Q, down from the blistering 8.2% pace in the 3Q.  Recent data indicate that while the economy is on solid footing, it is not likely to return to the ozone level seen in 3Q 2003.  BCA now forecasts that the economy will grow by 4-5% in 2004.  It is generally agreed that growth of 4-5% will not result in a significant increase in inflation.  Thus, the editors believe this gives the Fed the opportunity to avoid having to raise rates in an election year.  They say:

“The odds of a mid-year monetary tightening [rate hike] have diminished. It will take three or more months of solid employment gains and a rise in inflation before the Federal Reserve raises rates.”

Alan Greenspan does not want to raise interest rates this year.  He does not want to open himself up to political criticism.  As noted earlier, the latest reports indicate that inflation rose only 1.9% in the 12 months ended January.  Unless there are new indications that  inflation is beginning to rise more than currently expected, Greenspan has the luxury of doing nothing.  Fortunately for him, the inflation data in the latest GDP report look fairly benign.  As a result, BCA believes the odds are now good that the Fed will not raise interest rates this year.

BCA On The Investment Markets

Stocks.  BCA believes the trend in equities will  remain higher and continues to recommend fully invested positions in equities.  The improving economy, the healthy corporate profit outlook and the benign inflation environment should provide good support on any significant market downturns.  The editors also do not rule out another overshoot on the upside in equities in 2004.  A mountain of cash is still sitting on the sidelines in money market accounts, which could drive prices higher than otherwise warranted.  As a result, BCA recommends holding “above average” (fully invested) positions in equities for the time being.

On the other hand, the BCA editors caution that the bull market in equities is reaching an advanced stage, especially given the huge gains in 2003.  Furthermore, while they feel that interest rates may remain steady for the balance of this year (or at least until after the election), the next major trend in interest rates is higher.  Looking down the road, then, the editors believe that investors may be wise to look to take profits sometime later this year, especially if equity prices overshoot on the upside once again.  I will keep you posted on their latest recommendations.

Bonds.  BCA continues to recommend “below average” positions in Treasuries and other high-grade corporate bonds.  They believe that Treasury yields are being held below where they should be in this strong economic recovery by aggressive Fed monetary policy and unusually large purchases of government debt by foreign central banks.  While BCA expects the Fed’s low interest rate policy to continue until at least after the election, they emphasize that our dependence on large  foreign purchases of Treasuries is a potentially dangerous situation.  I agree.  In short, they see little upside potential in Treasuries from current levels, and significant risks on the downside.  As a result, they recommend that investors continue to under-invest in Treasuries and other high-grade corporate bonds. 

The USDollar.  The editors suggest that the US dollar may be in for a period of “temporary calm” (a correction) before resuming the major downtrend.  Since its peak in early 2002, the dollar has declined over 30% against the Euro.  Given the extent of the decline, and given that this is an election year, the editors expect the dollar to move generally sideways in the months ahead, perhaps until early next year.  After that time, they believe the dollar will resume its downtrend, falling to new lows against most major currencies.

Given a trend of this magnitude, a period of “temporary calm” could be anything but calm.  If BCA is correct that the initial phase of the bear market is over, we should not be surprised if the dollar stages a significant rebound, even if it is only a correction.  If the dollar rebounds much, it could trigger a huge volume of short covering.  Thus, if you have been looking to short the dollar vis-a-vis a currency play, you may want to wait awhile for a better opportunity.

Gold.  BCA has been silent on the gold market for most of the last year, which suggests they don’t have an opinion.  Gold has retreated from its highs around $430 to below $400 once again, most likely due to the good inflation reports recently and the improving news in Iraq.  At this point, I don’t have a strong opinion on gold either, but I’m not a big bull on the yellow metal.

Investment Conclusions

Investment risks are clearly higher in 2004 than last year.  Let me count the ways.  Stocks have risen over 30% in the last 12 months, and while they may yet go even higher, the slightest negative surprise could send these markets tumbling.  Most analysts believe interest rates will remain very low for the next year.  Yet rates have to go up sooner or later, and Alan Greenspan admitted as much in a speech on March 2.  Whenever there is a hint that rates are about to rise, bonds could get clobbered again.  The US dollar has plunged over 30% against the Euro in the last year.  While there are widespread predictions that the dollar will move much lower, any surprises in this area could lead to a significant reversal as discussed above.

Given the higher risks we face today, Inow more than ever recommend that you use professional “active management” strategies that can protect your portfolio in these uncertain times.  You need managers that can “hedge” their positions and/or move out of the market from time to time should conditions warrant.

Scandal Prompts Questionable Reforms

The investigations into mutual fund families that allowed illegal after-hours trading and other trading abuses in their funds continue to widen.  The mutual fund scandals that were made public late last year and since have led to a plethora of proposed new regulations.  Sadly, some of these new proposals have the potential to harm investors more than punish the mutual fund families who have been guilty of abuses.

The regulators at the SEC are working overtime to come up with ways to prevent these abuses.  Several groups within Congress are also racing to pass new legislation, all in the name of protecting investors.  Yet powerful lobbies for the mutual fund industry and the brokerage community are seeking to take advantage of these developments for their own benefit.

The bottom line: some of these new remedies will very likely result in higher fees paid by mutual fund investors; required holding periods for funds, with penalties should you have to withdraw money early from a fund due to an emergency; and in the end, could line the pockets of the mutual fund industry.

The Anatomy Of A Scandal

Last September, New York Attorney General Elliot Spitzer shocked the investment world when he named several well-known mutual fund families in a complaint for “late trading” and improper “market timing.”  On the late trading issue, these funds were allowing large customers (mostly hedge funds) to make trades after the markets closed.  In essence, it was like betting on a horse race after it had already been run.

The market timing issue was mis-named from the start.  What Mr. Spitzer inadvertently referred to as market timing is actually known as “international arbitrage” or “time zone arbitrage.”   Here is a quick summary of how it works.  International mutual funds sponsored by US firms hold foreign stocks that are traded on foreign exchanges.  These foreign markets open and close at different times and in some cases, the time zone differential can be up to 12 hours.  The Asian stock markets, for example, close during the night in America, well before US stock exchanges open in the morning.  News can occur after the Asian (or other) markets close that can significantly affect their share prices, up or down, the following trading day.

Traders who monitor such news can purchase US mutual funds that they know hold the affected stocks in Asia (or elsewhere), anticipating that the price of the US funds will go higher.  For example, let’s say the Asian markets close on a Tuesday night in the US, but news comes out after the close that should make those share prices move higher the following day. A trader could, on Wednesday, buy US mutual funds that he knows holds those stocks which will be affected by the news.  The Asian markets adjust higher to the news on Wednesday, after our markets have closed.  US mutual funds react higher as well, but on Thursday.  Then the trader sells.  He buys one day and sells the next, often reaping a nice profit.

Enforcement Is The Problem, Not Market Timing

So is this “market timing?”  It is in an international sense and to the degree that it results in a lot of short-term trading in these types of mutual funds.  However, this international fund arbitrage is in no way similar to the traditional market timing strategies which have been practiced by investment professionals for decades.

Now here’s why this is an enforcement problem.  Many mutual funds have a written policy that prohibits short-term trades.  Some funds even impose an early redemption fee for doing so.  However, in the mutual fund scandal, some funds chose to ignore this short-term arbitrage trading by insiders and large, preferred customers.  They were not charged the early redemption fees, even though regular customers of the fund were subject to these fees. 

The problem was not that there were no rules in place, or that the funds didn’t know about the short-term trades.  The funds simply chose not to enforce the rules for certain investors because it was profitable for them.  Sorry folks, that’s not market timing - but it is illegal - and some funds are now in trouble for it.

It is unfortunate that Mr. Spitzer used the wrong term - market timing - to describe the short-term trades that some large traders used to make good on their late-trading and arbitrage opportunities.  Yet the financial press and mutual fund industry have jumped on the term market timing and have portrayed it as something illegal, and this was not by accident.  This is helping the fund industry take advantage of a bad situation.

The Inside Story On Market Timing

As noted above, traditional market timing  as we know it has been practiced for decades.  What you may not know is that professional managers who use  traditional market timing strategies within mutual funds are generally disliked by the mutual fund industry.  There are several reasons for this. 

For years, most mutual fund families and brokerage firms have preached that investors should simply “buy-and-hold,” meaning that you buy their funds and hold them for a very long time.  There’s a good reason for this.  The longer you stay in, the more money they make!  Any investment strategy that takes money away from them - as traditional market timing does periodically - must be bad.

For years, the fund families and brokerage firms trotted out arguments about how market timing doesn’t work, even though many of those arguments were flawed.  Yet when Mr. Spitzer used the term market timing to refer to the improper trading practices going on, the mutual fund industry jumped all over it!  Their friends in the financial press (who are also strong adherents to the buy-and-hold myth), readily ran stories that made market timing sound like something  illegal, or at least highly unethical.

The Proposed Remedies - Look Out!

There’s nothing like a good scandal to wake up politicians as well as regulators.  Since Spitzer’s first announcement last September, both the SEC and Congress have proposed solutions to the mutual fund late trading and so-called market timing problems.  Unfortunately, some of the new proposals are almost as bad, or worse, than the activities they seek to prevent.

One rule being proposed by the SEC and in Congress, is a so-called “HARD CLOSE” at 4:00 PM EST.  Most investors don’t think much about this, since they know this is when the stock exchanges close.  However, it is less well known that mutual funds often continue to take trade information, including orders to buy and sell, from intermediaries (such as 401(k) administrators and mutual fund supermarkets) well after the 4:00 PM close.  In fact, some 401(k) transactions are not transmitted until the following morning.  The fact is, there is nothing wrong with this practice.

A 4:00 PM hard close will require all orders to be received by the mutual funds by the time the exchanges close - no exceptions.  On the surface, this rule sounds good; if everyone has to get their orders in by 4:00 EST, then there’s no opportunity for late trading abuses.  Yet in reality, this rule will be very onerous. 

As it stands now, you can call most mutual fund companies by 4:00 and place a trade.  However, if we go to a hard close, all fund companies will have to implement an earlier cut-off time for orders to be placed.  Some families will go to a 3:00 EST cut-off, while others may be even earlier, say 2:00.  Investors on the West Coast, for example, would have to place their orders by noon or even 11:00 in the morning. While the hard close rule may sound reasonable, the net effect will be to push cut-off times for transactions earlier and earlier.  This will actually penalize investors by removing some of the flexibility they have in the timing of placing orders.  In short, everyone would be penalized for the actions of a few!

Mandatory 2% Early Redemption Fee

Another proposal by the SEC and Congress is a mandatory early redemption fee of at least 2% if a fund is redeemed within a short period of time (usually 5 days).  Guess who loves this idea?  The mutual fund families and the brokerage community, of course!  Due to intense competition, the mutual fund industry has been forced to lower fees over the last decade.  Investors have demanded it.  Many mutual funds have elected not to charge early redemption fees as it put them at a competitive disadvantage.  If you could put your money with one fund family and move it without a fee, then why would you want to invest with another family that charged such a fee?  Now, the new rules would require most funds to charge the fee. Not surprisingly, the Investment Company Institute (ICI), the huge mutual fund trade association, wholeheartedly supports the 2% fee proposal.  If the mutual fund lobby has its way, mutual funds will be able to charge early redemption fees and blame the SEC and Congress for making them do it!  How nice for them!!

There is another point to be made against the mandatory redemption fee.  Investors rarely read  fund prospectuses, and many will not even know about the early redemption fee until it is too late.  There will  continue to be many investors who buy a fund but decide to change their minds a day or two later.  If this new proposal is adopted, many people won’t know they are getting hit with a 2% (or higher) fee until it’s already deducted from their accounts.  Here again, everyone is penalized for the actions of a few!

They Need To Take Responsibility

Just to recap, the mutual fund industry is responsible for allowing corrupt practices that led to investor losses and legal action by the New York Attorney General and others. The funds knew the large customers that made most of the illegal trades. They could have enforced their own written policies and kicked them out.  But they didn’t because the business was highly profitable.  Yet not only does the industry refuse to take responsibility for its actions (or inactions), they now support remedies that penalize everyone and will only serve to line their pockets with new fees.

A 4:00 PM hard close will only reduce investors’ flexibility, especially those with money in retirement plans and those in the western time zones. The mandatory 2% (or higher) early redemption fee is another bad idea.  Fortunately, there are other proposals before Congress that would take a more balanced approach to solving the problems within the mutual funds.

How About Some Sensible Remedies?

The most rational proposal I have seen to combat the practice of international arbitrage is to require mutual funds to use what is called “FAIR-VALUE” pricing.  This is a complex procedure, but in short it means that the mutual fund families would be required to use various factors such as late-breaking news,  after-market developments, futures market trends, etc. to determine a daily estimated fair-value price for each foreign stock held within an international mutual fund.  Doing this would provide investors with a “best-efforts” price for their mutual funds, but most importantly, it would greatly reduce the price differentials that these insiders trade upon.

Of course, the mutual fund industry and the ICI oppose mandating this form of pricing.  Why?  For one thing, the process of determining a fair-value price for a mutual fund is time consuming and expensive.  Never mind that it is better, fairer and eliminates the chances for abuses.  No, it’s a lot easier and less expensive to implement a 4:00 PM hard close.

On February 9, The Mutual Fund Reform Act of 2004 was introduced by a bipartisan group of Senators and genuinely seeks to correct the problems in the mutual fund industry by attacking the underlying governance and “transparency” issues inherent in the industry.  In my opinion, this legislation speaks to some of the core problems of the mutual fund industry without negatively affecting innocent investors.  The big difference between this and other bills is that it is not a band-aid fix directed at the symptoms of the problems, but a bill that gets at the root causes. 

One of the chief provisions of this bill is that it makes the board of directors of each mutual fund more responsible to its shareholders.  It does this by ensuring the board is truly independent of the fund family, requiring fund management to adopt a code of ethics, and by empowering the board to exercise its fiduciary duties to protect shareholders.  It also requires fair-value pricing and strengthens enforcement of the short-term trading and early redemption fee rules that are already in place.   Aside from addressing issues related to the mutual fund scandals, the bill also seeks to improve the transparency of mutual fund fees and actually prohibits mutual fund practices such as charging 12b-1 fees and bonuses to brokers who promote a fund’s shares to investors. In my opinion, the Mutual Fund Reform Act would effectively address the root causes of the mutual fund scandals by making some major changes in the way the fund industry does business.  We should support this bill as suggested below.

Not surprisingly, the ICI, and the mutual fund industry in general, oppose this legislation. ICI president Matthew Fink says this proposed legislation “contains many ill-defined new legal standards that could change mutual funds’ essential structure,” that “would seriously jeopardize the interests of current and future mutual fund investors.”   Really???

Excuse me, but wasn’t the current mutual fund “modus operandi” (ie - selective enforcement of rules and special deals for big investors) the cause of the current problems?  Sounds to me like the only interests being seriously jeopardized belong to those in the mutual fund industry who want to profit at the expense of the shareholders!  I believe the Mutual Fund Reform Act is right on target, and I encourage you to contact your Senators and show your support for Senate Bill S.2059.

Conclusions

I hope this discussion about the ongoing efforts to solve the problems in the mutual fund industry has been helpful.  I continue to believe that mutual funds are an important part of an investor’s portfolio, and I haven’t lost my faith in them.  I believe the mutual fund industry will emerge from these scandals stronger then ever, but with much greater shareholder protection and disclosure requirements. 

Obviously, the fund industry is leaning toward some “quick fixes” that could penalize investors and reduce flexibility.  Yet the last I heard, you don’t allow the wrongdoers to make the laws and regulations intended to prevent their illegal activities.  However, that’s exactly what is happening in the mutual fund scandals even as this is being written.  The ICI has testified before Congress and has strongly supported the SEC’s 4:00 PM hard close and 2% minimum early redemption fee proposals, and is lobbying hard on Capitol Hill.  We need to stop them!

At the same time, there are plenty of Senators and Representatives in Washington who can’t wait to attach their names to new legislation being touted to protect investors.  Unfortunately, there are many in Congress who either do not understand the issues, or can be bought by the ICI, or both.  Our leaders need to understand that the foxes are in the hen house! 

We don’t need a 4:00 PM hard close.  We don’t need a mandatory early redemption fee.  The fund families need to police their own rules.   They should kick out those who would abuse the flexibilities of the system.  At the end of the day, they just have to do what is right.  With $7 trillion of our money in mutual funds, is that too much to ask?  I don’t think so!! 

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Editor’s Note

As most of you know, I have been writing my weekly E-Letters to an audience of apprx. 1.5 million people for the last year and a half.  I write 5-8 pages every week on a variety of topics.  Those of you who receive my weekly E-Letters have probably noticed that some of the same information is repeated in this monthly newsletter.  This is because some of our clients do not receive the weekly E-Letters, but they still need to read certain of the information contained in them.  This explains why you will see certain articles in both places. 

If you don’t receive my free weekly E-Letters, you are missing out on a lot of good information.  So, if you have a computer, be sure to get on our distribution list by giving us your e-mail address.  You can call us at 800-348-3601or e-mail us at mail@profutures.com.  Your e-mail address is strictly CONFIDENTIAL with us.  We never share your information with anyone.