Economic reports released over the last month were once again generally positive.  The index of Leading Economic Indicators was unchanged in the latest report as was the Consumer Confidence Index.  Consumer spending was slightly higher as well.  Retail sales rose 0.6% in February for the fourth consecutive month.  Durable goods orders rose in February also.  The employment picture finally improved markedly in March with over 300,000 new jobs created across industry lines.  Meanwhile, corporate profits have skyrocketed in the last six months.  The Bank Credit Analyst remains optimistic about the economy.  They expect GDPgrowth of 4% this year and 3-4% in 2005, barring any major negative surprises.

With the latest good news on the employment front, discussions have shifted once again to the question of when the Fed will raise interest rates.  As discussed last month, BCA continues to believe the odds are good that the Fed will not raise rates this year, or at least not until after the election.   As a result, BCA believes that the equity markets will recover, perhaps strongly, in the next few months and go into the election on a strong note.  They also believe Treasury bonds, which have enjoyed a nice rally recently, will again come under pressure in the weeks and months just ahead.

Given BCA’s forecast and the recent action in the markets, I see an excellent opportunity now for investors looking to get back into (or add to) equities, as well as another opportunity in high-yield bonds.  The recent pullback in the equity markets may be the best opportunity for investors to get back in or add to positions.  Also, with the surprisingly strong growth in corporate profits, high-yield bonds could show another strong performance during the remainder of 2004.  Right now may be the best time this year to consider our professionally managed equity programs and our high-yield bond program.  See my specific recommendations on page 4.

This month we will also look at the major factors which have driven gasoline prices to new highs recently.  There is a lot of disinformation out there regarding oil and gasoline prices, and I try to give you the straight story.  Bottom line: oil and gasoline prices are likely to remain high and may go even higher.  My analysis follows on pages 6-8.

The Economy & Unemployment

BCA continues to believe that the recovery in the US economy remains on very solid footing.  The editors remain convinced that the economy will grow by 3-4% or better in 2004 and barring any major surprises, will repeat in 2005.  In their latest April issue, the editors emphasized that all the elements are in place, at long last, to see a substantial improvement in the employment situation in the US.  Sure enough, the latest employment report released on April 2 (after BCA’s latest report was sent to subscribers) showed that over 308,000 new jobs were created in March across the business spectrum.  

The BCA editors focused special attention on the continued improvement in corporate profits, which have skyrocketed in the last year.  Total corporate after-tax profits rose by 31% (year over year) in 2003 to a new post-WWII high.  BCA says: “The growth in profits during the last year has far surpassed expectations and reflects the combination of solid volume growth, booming productivity and tight control over costs.  The weak dollar gave an additional boost to overseas profits last year.” 

The editors believe that this big growth in profits will continue over the next year and will spur impressive growth in job creation over the coming months.  The editors point to a variety of other indicators which suggest that the long-awaited rebound in job growth is  finally unfolding.  But don't expect to read about this in the media!

It is rare to find political overtones in BCA's analyses, but the editors had the following to say in their April issue on the issue of employment: “In sum, there is a compelling amount of evidence suggesting that employment will soon improve. The quicker this happens the better, given the unfortunate and misguided spotlight on overseas outsourcing as a major culprit behind the weak labor market. Media hype about outsourcing is triggering a political response, with dangerous protectionist undertones.”  [Emphasis added, GH.]

Clearly, the BCA editors are concerned that a political shift in the US (ie - a liberal Democrat like John Kerry in the White House) could result in new protectionist trade policies that could be dangerous.  A discussion of the dangers of protectionism could more than fill the remaining pages of this newsletter, so we will defer that topic to another time.  However, I do think it is noteworthy that the BCA editors would veer from their usual non-political position to issue the caution above.

Consumer Spending Still In Good Shape

For the last two years, we have been told by the media that consumers are “tapped-out” with the record large amount of debt.  Yet consumer spending has been on a steady increase ever since the end of the recession in November 2001.  Personal consumption expenditures rose again in the latest reporting period and are up 7.2% in the last 12 months.

It is true that household debt levels are at a record high.  However, as I have written several times over the last year or so, over 70% of all consumer debt is in the form of home mortgages which are well collateralized.   As you will recall from previous issues of F&T , BCA has steadfastly argued that US consumers were in better overall financial shape than the media would have us believe.

BCA continues to believe that consumer spending will remain firm over the next year.  While consumer debt levels remain high, and the savings rate low, the BCA editors believe that consumer spending will continue to surprise on the upside in 2004 and 2005 as it has for the last couple of years.  This is just one more reason why the economy is likely to continue growing at a healthy pace.

The Interest Rate Outlook

With the latest good employment news, analysts are again questioning when the Fed will raise interest rates.  BCA’s most likely scenario continues to be that the Fed will not raise interest rates this year.   The editors believe that the Fed is still concerned about the deflationary threat that existed in late 2001 and 2002, and will defer any interest rate hike until it is even more obvious that the inflation rate is back on a moderate rise. 

Such a policy by the Fed may seem strange, since the Fed has been fighting inflation for the last 20 years or longer.  However, the US economy flirted dangerously close to deflation during the 2000-2001 recession, and BCA believes this scared the Fed into a new policy.  BCA maintains that, unlike in previous years, the Fed will keep interest rates abnormally low until they are sure that the deflationary threat is dead and gone.  Specifically, they believe the Fed  wants to see inflation trends begin to rise modestly for at least a couple of quarters before they raise short-term interest rates.

BCA maintains that the most likely time for the Fed to raise rates for the first time will be in early 2005.  The editors admit they could be too optimistic and they offer the following analysis:

“At least three months of solid employment gains will also be needed… This leaves open the possibility of a rate hike in August, but the odds are much less than 50%.  Then we have the problem that the Fed will not want to raise rates too close to the November elections.  ... the next realistic opportunities will be at the December [2004] or January [2005] FOMC meetings.

Even once rates start to rise, the Fed will move gradually in order to avoid causing too much market turmoil.  The implication is that monetary conditions will stay very accommodative for the foreseeable future.   This should be bullish for both the economy and the stock market."

BCA On Stocks & Bonds

The recent decline in equity prices has once again brought out the gloom-and-doomers in force.   Predictions of a new bear market are everywhere again.  Actually, the recent stock market decline has been mild by historical standards, and this may prove to be the best buying opportunity this year.  BCA says:

“The stock market has been supported by two main pillars: a healthy trend in corporate earnings and a favorable monetary environment. ... the cyclical bull market will not be at serious risk until the monetary environment becomes restrictive... That is not a nearterm threat.”

The editors believe that upcoming employment gains will be the trigger that sends stocks above their January highs.  As a result, they recommend that investors maintain (or move to) fully invested positions in stocks.  As discussed on the following page, the BCA editors once again emphasize that “market timing” and “sector rotation” strategies offer the best potential in the current equity environment.

The Treasury bond market has enjoyed a strong rally in recent months following the volatile year in 2003.  Yet BCA warns that the T-bond market is very vulnerable this year given the strong economy.  In fact, the latest strong March employment report sent bonds reeling as it suggested higher inflation down the road.  Also, when the Fed finally begins to raise interest rates, BCA believes we will see a new bear market in long bonds.  They say: “The Treasury market will be very vulnerable when the market revises its expectations of Fed policy.”

On the one hand, the Fed is not expected to move to higher rates until late this year, so T-bonds could continue to hold up a while longer.  On the other hand, good economic news will continue to cause problems for the T-bond markets as we have seen in early April.  At some point, maybe even before you read this, large bond players may begin to unload their holdings.  If so, look out below.

What To Do Now

Based on discussions with clients, prospective clients and others, we know that many people still have not moved back to a fully invested position in equities since the end of the bear market.  Despite my repeated recommendation in late 2002, some have remained out of the equity markets almost entirely, while others took only partial positions, all the while waiting for an opportunity to get back onboard.  As we all know, stocks didn’t offer many good opportunities to get back in last year.

The recent decline in equity prices may be the best opportunity we see this year.  No guarantees, of course, but now may be the time to get back in or add to positions.  The economy is on solid footing, corporate profits are soaring, the Fed is not likely to raise rates anytime soon, and election years are historically bullish for equities in general.  Thus, if you have been looking for a place to make a move, now may very well be the best time this year.

As suggested on the previous page, BCA once again recommends the very types of equity strategies that Ihave recommended for years.  They say: “Equities should be the superior asset class, with the caveat that market timing and sector selection will become more important.”   [Emphasis added.]

Niemann &Potomac Fit The Bill

Niemann Capital Management and Potomac Fund Management are both ideal choices for the current stock market environment.  They both can be fully invested, partially invested, out of the market altogether or “hedged” as conditions warrant.  They both utilize fund selection strategies which help them be in the more attractive market sectors at any given time.  This type of flexibility and defensive strategies are key in the current environment.  Both Niemann and Potomac delivered outstanding results in 2003 during the initial stage of the bull market.  More importantly, both have managed to deliver positive results even this year when the markets declined.  (Past results are not necessarily indicative of future results.)

If you have been looking to get back in the equity markets, I strongly suggest you consider Niemann and/or Potomac now.  This may also be an excellent time to consider adding to existing accounts.

  *Editor’s Note: Please see additional information on Potomac on page 8.*

High-Yield Bonds Set For Another Run?

As discussed on the previous page, BCA expects Treasury bonds to come under pressure again this year.  Likewise, they expect the surge in corporate profits to benefit other types of bonds, including high-yield bonds.  Here too, now may be the best time this year to consider Capital Management Group, our recommended high-yield bond Advisor.

Following their outstanding year in 2003, CMG has been relatively flat during the 1Q of 2004 as Treasury bonds have been in the spotlight.  Yet if BCA’s forecast is correct, the high-yield bond markets could get hot again this year, while T-bond funds may again hit a rocky road in the coming months.

Like Niemann and Potomac, CMG can be fully invested, partially invested, out of the market altogether or “hedged” as conditions warrant.  CMG invests in large, highly diversified and carefully selected high-yield bond funds.  If you have been looking to diversify into this area, now may be the time to consider CMG.  Also, if you are invested in Treasury bonds, this may also be a time to consider reducing those investments.

I invite you to call us today at 800-348-3601 for more information on the programs above.  Or check out these programs at www.profutures.com. 

Gasoline Hits Record High

Gasoline prices hit an all-time record high in March.  AAA reported that the average price for a gallon of regular unleaded gas across the US hit $1.76 on March 29.  In California, gasoline prices topped $2.10 per gallon on average in late March.  Consumers are complaining that the government should do something, and many are crying foul play by the big oil companies.  This is nothing new.

OPEC oil ministers met in Vienna on March 30 and decided to cut daily oil production beginning on April 1, but this is not likely to happen.  As you will read below, OPEC has been cheating on production quotas for the last six months, and they’re not about to stop now with the current high prices.

The Bush administration was disappointed with OPEC’s decision as it has been lobbying allies in OPEC to increase, not decrease, oil production.  So much for that plan.  John Kerry, announced his new plan for lowering fuel prices on March 30, with the same lame ideas we’ve heard in the  past.  Below I’ll tell you why neither Bush nor Kerry will lower gasoline prices significantly anytime soon.

In fact, gasoline prices are likely to continue to increase as we head into the peak consumption period from May to August.  Most consumers do not plan to cancel travel plans and stay home this summer just because gas prices are 11-15 cents a gallon higher than a year ago.  As I will discuss below, there are no quick fixes to the current energy problem.

The bottom line is that global demand for oil and energy products is booming.   Gasoline consumption is rising rapidly, not only in the US but also in China, India and elsewhere around the world.  Meanwhile, inventories of crude and refined fuels are the lowest in years.  In addition, some of the major producers of sweet light crude, the grade of oil best suited for making automobile fuel, are reaching capacity limits.  Add to that a global energy transportation shortage, and you have all the ingredients for higher prices.  In the pages that follow, we’ll look at these issues, but I would not plan on gas prices falling significantly anytime soon. 

Short-term Dip, But Then Even Higher

In the last few days, futures prices in light sweet crude have dipped from near $38 per barrel to near $35.  Deliveries of crude to US ports and shipments to refiners have increased slightly over the last few weeks as well.  The latest reports also showed that domestic inventories of oil and gasoline have risen slightly. This suggests that we could see gasoline prices dip several cents per gallon in early April, but that is far from certain.  Events in the Middle East, especially in Saudi Arabia and Iraq, will continue to buffet energy prices in both directions.  But at this point, with supply and demand so tight, most surprises will send prices higher not lower.

Absent a major positive surprise, gasoline prices are likely to trend even higher until at least mid-summer.  Over a month ago, the Department of Energy forecast that gasoline prices would rise to at least $1.80 per gallon on average during the peak summer travel season.  Now that the average price has spiked to $1.76 - and it’s only April - there is wide agreement that the DOE’s forecast of $1.80 is probably at least 10 cents a gallon too low.  Some analysts are predicting that the average price will hit $2.00 nationwide this summer.

OPEC - What They Do, Not What They Say

OPEC’s latest decision was to decrease the “official” daily production quota from 24.5 million barrels per day (mbd) to 23.5 mbd, not including Iraq.    Several OPEC members opposed the cut in the quota, but Saudi Arabia forced the decision.  But OPEC’s daily production quota has never been adhered to strictly; it’s what they actually produce that counts.  For example, OPEC’s actual daily production has been running at 25.5-26.0 mbd since last September.  As always, OPEC members tend to cheat and produce more whenever prices are high.  Expect this to continue.

Keep in mind that oil and gasoline prices have shot higher in the last six months even though OPEC has been producing above its quota level.  President Bush and other world leaders have been calling on OPEC to produce even more than the 25.5-26 mbd.  Ishould point out, however, that only Saudi Arabia, Kuwait and the United Arab Emirates have the ability to significantly increase production.  These large producers have not indicated a willingness to increase production significantly, especially not Saudi Arabia.  With OPEC’s latest quota decision, production may not decrease, but it likely will not increase either.  This is another reason why high gasoline prices are likely to continue, and may even go higher in the months ahead.

Declining Availability Of Oil Used For Gasoline

Here is another reason why gasoline prices are likely to remain high.  Sweet light crude and brent crude are the primary choices for refining into gasoline, and this raises another bottleneck.  As noted above, OPEC does have the ability to increase production, but this excess capacity is primarily in the heavy and medium grades of crude oil, which are not generally used in making gasoline.  Saudi Arabia, Kuwait and the UAE are reportedly near their limits on production of sweet light crude. 

There are more reserves of sweet light crude around the world, including in the Arctic National Wildlife Reserve, but the energy industry currently doesn’t have enough capacity to pump it.  As I will discuss below, it is a given that the industry will increase its capacity to produce light sweet and brent crude as a result of exploding demand for gasoline and the current high prices, but that will take time.  Meanwhile, more refineries around the world are being reconfigured to use heavier oils, but it is a complex, expensive and time-consuming process. 

Along this line, many consumers are asking why the other oil exporters of the world can’t increase their production to cool world oil prices.  OPEC only accounts for one-third to one-half of all world oil exports.  Part of the answer is that some of the other major exporters face similar constraints on the amount of sweet light crude they can produce.  Another part of the answer is that political upheaval has reduced the ability of several countries to produce and export oil, including Venezuela, Nigeria and Indonesia.  Iraq is producing at only a fraction of its capacity.    Even Russia's production has come into question amidst the recent serious scandals in its oil industry.   

Refining Capacity Has Also Grown Tight

The subject of capacity to refine crude oil into gasoline is one that is rife with debate and controversy.  Critics of “big oil” believe this is the one area of the energy equation where the oil companies have been the most guilty of price-gouging the public.  The oil companies, on the other hand, claim it is the mountain of environmental restrictions and regulations that have led to the capacity shortage in refining.  Both sides have very strong arguments (some correct and some incorrect), but I do not have space to sort them out in this issue.

Suffice it to say that the capacity to refine crude oil into gasoline is growing tight (regardless of the reasons).  Five years ago, global refining capacity showed a surplus over demand of 5.7 million barrels a day.   Back then, we had a glut.  Now, with the exception of plants that are seasonally down now for repair prior to the peak season, global refining is running flat out.  PFC Energy, a well-known Washington consulting firm, estimates that even with all refineries back online, global demand will exceed refining capacity by the end of this year.

While refineries are constantly finding ways to increase production, we are approaching hard limits according to industry sources.  The oil industry hasn’t built large numbers of new refineries in recent years and others have been shut down due to their age, low profit margins and/or environmental concerns/regulations. 

Another problem is that the oil industry has reduced its reserve inventories of crude oil and gasoline stocks in recent years in order to cut costs and avoid tying up capital.  Here, too, there are strong arguments on both sides, especially with oil companies earning record profits now in some cases.  Arguments aside, reduced inventories mean there is much less of a cushion to make up for production shortfalls and/or supply interruptions, and we are more susceptible to price spikes.  This could be especially true on a regional basis this summer given that there are so many different standards for gasoline in different parts of the US. 

I hesitate to bring it up, but this also raises the question of terrorism, especially in light of the current very tight supply situation.  As this newsletter is written, the FBI has issued a terror alert for the refineries in Houston.  Generally speaking, the nation’s petrochemical facilities are not well secured.  Were there to be a successful terrorist attack that disrupted the oil and gas supply chain in the US (or elsewhere), prices could escalate sharply, even from current levels.

Bush & Kerry's Plans Are Just So Much Talk

The discussion above would suggest that oil and gasoline prices are going to remain generally high for some time to come.  Yes, there will be periodic downswings in prices, as I will discuss below.  But for now, and especially the next several months, we should expect to see high prices continue and most likely get even higher, despite what President Bush or John Kerry say.

The Bush administration has not advanced any new initiatives directly aimed at bringing down gasoline prices in the near-term.  Early-on, Bush floated the idea of drilling in ANWAR, where there are known reserves of sweet light crude, but that idea was roundly shot down by the liberals and environmentalists.  More recently, the Bush administration reportedly has pressured allies in OPEC to increase production, but as discussed above, this is not likely.   While continually accused of being in the back pockets of the big oil companies, the Bush administration recognizes that oil and gasoline are “commodities,” the prices of which are much more governed by supply and demand than by Washington directives.

John Kerry announced his new plans for reducing gas prices at the pump in the last week of March.    Kerry says that, unlike Bush, he will be successful in convincing OPEC to produce and export much more oil.  Never mind the discussion above to the contrary.  Kerry said he would halt oil shipments being used to replenish the Strategic Oil Reserve and send those supplies into the marketplace.  Using the Strategic Reserve to try and manipulate the price of oil and gas is a tired, old argument.  The Reserve is too small to make a significant difference, and let us not forget that it is there for national security. 

The bottom line is that neither Bush nor Kerry can do much, if anything, to make oil and gas prices go down in the near-term.  In fact, prices may well go even higher during the peak travel season just ahead.  If there are any major disruptions, prices could go a lot higher.

Looking long-term, and based on demographics, the demand for oil and gas will only go higher.  People in China and other developing nations around the world want cars and all the other consumer goods that use energy.   So long as the global economy continues to expand generally speaking, the demand for energy will only increase over time. 

High Prices Are The Solution for High Prices

There is an old saying among veteran commodities traders: “The solution to high prices is... high prices.”  Let me explain.  Commodity prices rise and fall based on supply and demand.  Both supply and demand are largely influenced by prices.  If prices go high enough, supply will increase and demand will decrease (and vice versa).  This is true in all commodities and especially in energy.

If energy prices remain high enough long enough, there will be: 1) more oil and gas exploration, more drilling, more tankers, more refineries, etc. and increased supplies; and 2) either reduced demand or at least a slowing of the increase in demand.  Higher prices also mean increased research and development of alternative sources of energy and more energy efficient products.  This process historically leads to lower prices, and the cycle then repeats itself over time.

It is important to note, however, that these cycles vary widely in length, and I believe the current trend of higher energy prices will prove to be a longer-term cycle.  Let me repeat again that there will be periodic downswings in prices, and some will undoubtedly be big ones.  However, the demand fundamentals in the energy world are daunting. 

The Bull In The China Closet

The numbers from China alone are immense.  China’s demand for oil is projected to more than double by the end of this decade.  Ditto for most other commodities.  China is already sucking in vast amounts of commodities from all over the world.  China is a big reason why we have seen a major bull market in virtually all commodities over the last 2-3 years, including some markets that had been generally depressed for a decade or longer.  While China is the 800-pound gorilla, demand for energy and commodities is increasing rapidly throughout most of the developing world.

Given the booming demand outlook, the bull market in energy and commodities prices may continue, perhaps for several more years.   Again I must emphasize that there will be some serious downturns along the way; commodity prices don't move in one direction only.  However, I can see the bull market in commodities continuing for some time to come.

Conclusions

In the preceding pages, we have looked at some of the major reasons why oil and gasoline prices are where they are today.  Prices have risen substantially already, and it may still cost more to fill your tank in the next few months during the peak travel season.  Historically, gas prices should come down some after the summer.  But that could be temporary.

The current high prices in the energy sector will contribute to increasing supplies in a variety of ways.  Some of the oil exporting countries that have reduced production due to political upheaval have great incentives now to get back full production.  Iraq will be steadily increasing output.  The recent high prices will begin to stimulate new production of sweet light crude for making gasoline.  Refining capacity should increase slowly.  All of these developments will serve to bring down prices or slow the rate of increase - at least over the next six months to a year.  Yet longer-term, I can see the bull markets in energy and commodities prices continuing - in their normal, very volatile manner with plenty of downs to go along with the ups.                                                                  *      *      *      *      *

Editor’s Note:
Potomac Changes Name Of Its
Fidelity Conservative Growth Program

Potomac Fund Management recently announced that it is changing the name of its Fidelity Conservative Growth Program to the “Guardian Program.”   This is a name-change only.  The program will continue to be managed just as it has in the past.  We have continually recommended this program to clients since we began our ADVISORLINK service in 1996.  If you have not looked at this excellent equity fund program, you should.  In case you missed it, be sure to read my latest investment recommendations on page 4.