In this issue, I bring you the latest thinking from the editors at The Bank Credit Analyst.  As always, I consider BCA to be one of the most accurate forecasters of major economic trends, equity market trends and interest rate trends.  In short, BCA predicts that the economy will continue to grow at a healthy rate of 3-4% over the next year, barring any major negative surprise such as another major terror attack on our soil.

The economy did slow somewhat in the 2Q. The Commerce Department released its first estimate of 2Q economic growth at 3%, which was below expectations.   The Index of Leading Economic Indicators and the ISM manufacturing index both fell slightly in June (latest data available), but both readings are still above where they were at the beginning of this year.  Also, the Consumer Confidence Index rose again in July to the highest level in two years.  BCA believes that the latest slowdown does not mean a new recession, and the economy will continue to grow.

As this is written, the stock markets have fallen to new lows for the year.  Does this mean a new bearish trend has developed, or are we still in a broad trading range?  BCA still believes that stocks have upside potential between now and the end of the year.  However, due to recent market action, the BCA editors lowered their recommendation on stocks from “above-average” to “average.”  They also recommend traditional market timing strategies and sector rotation for this type of market (see pages 2-3).

As investors struggle in this choppy equity market, many are reaching for riskier strategies in the hopes of increasing returns.  Investment promoters know this, and there is a ton of bad advice out there.  This month, we look at some of the bad advice and why you need financial planning.

The editors at BCA continue to believe that Treasury bonds and other high-quality long-term bonds are overvalued, and they maintain their recommendation of “below-average” positions in these instruments. 

Finally, we take a look at the impact record high oil prices are having on the economy and consumers.  BCA has some interesting analysis on this  and a forecast for lower oil prices (see pages 7-8).

BCA’s Latest Forecasts

In this issue, I bring you the latest forecasts from our old friends at The Bank Credit Analyst.  I have not written about BCA’s latest thinking in a while because their forecasts and their recommendations haven’t changed in a while, until their current August issue.  As always, I consider BCA to be one of the most accurate forecasters of major economic trends, equity market trends and interest rate trends.  I have been a continuous subscriber to BCA since 1977.  Their research is quite expensive but well worth it.

Since the beginning of this year, BCA has maintained the following forecasts:

1.  The economy would continue to rebound, perhaps surprising on the upside.

2.  Inflation would turn higher, but not by enough to be overly concerned.

3.  The Fed would nudge short-term rates up in the second half of the year.

4.  Equity prices would trend modestly higher, especially in the second half - maintain above-average positions in stocks.

5.  Treasury and other long-term bonds are overpriced and are not advised - maintain below-average positions in long-term bonds.

With the exception of equity prices not rising to this point, Martin Barnes and his fellow editors at BCA got it pretty much right as usual. So what do they think now?

First of all, the BCA editors believe the economy will continue to grow by 3-4% for the next year, absent a major negative surprise such as another serious terrorist attack on our soil. 

They believe that inflation, as measured by the CPI, will settle in the 2-3% range.  They also believe the Fed will continue to nudge short-term rates up, such that the Fed funds rate is 4% or higher by the end of next year (2005).

BCA Downgrades Equities

BCA’s advice on the investment markets is either “above-average,” “average” or“below-average”  holdings.  After having recommended above-average holdings of equities over the last year, the BCA editors downgraded their recommendation to average holdings in their latest August issue.  They say:

“The stock market was due for a period of consolidation after rising 45% [S&P 500] between March 2003 and February 2004, almost without a break.   However, what should have been a ‘pause that refreshes’ is turning into a larger affair.  There is still a chance that prices will resume their upward advance in the second half of the year given still decent earnings growth and low interest rates...  The conditions for a major decline in stocks do not exist. 

…However, there needs to be a catalyst to trigger renewed investor confidence [in the market].  Investors are weighed down by a long list of concerns including oil, geopolitics, rising interest rates, the sustainability of the economic expansion and the outlook for earnings.”

As noted just above, the editors at BCA still believe the stock market may have some meaningful upside potential, but they also recognize that the markets could continue in a broad trading range.  In fact, their latest most likely scenario would have equity prices rising only about 5% over the next year.  If true, that will be a major disappointment to millions of investors.

The BCA editors also expect the equity markets to continue to be quite volatile.  They once again advise investors to consider traditional market timing strategies and sector rotation.  They say:

“In a low return world, market timing will become more important and this means paying more attention to short-run cycles… There will be lots of mini-cycles for nimble investors to play… Market timing and sector selection will become much more important in terms of boosting returns to more acceptable levels.” 

Right Up Our Alley

Most of the professional equity managers we recommend utilize strategies that emphasize sector selection.  Their time-tested systems attempt to identify those sectors that have the potential to outperform the market averages.  Few investors have the ability to do this successfully on their own, as I discussed last week. 

Most of the professional equity managers we recommend also have the ability to move partially or fully out of the market from time to time as conditions warrant.  Increasingly, these managers are using so-called “short funds” to hedge their long positions when it looks like the markets are moving into another downward move in their trading range.  Here, too, very few investors know how to successfully short the market during downturns.

If BCA is correct that the most likely scenario is for the equity markets to move in broad trading ranges, with a modestly higher bias, then you may want to consider active professional management for at least a part of your portfolio – even if you have never done so before.  I suggest you take a look at the successful active managers I recommend.

I recommend Niemann Capital Management and Potomac Fund Management for equities and Capital Management Group for high yield bonds.  You can see their actual performance records by going to our website at www.profutures.com or you can call us toll free at 800-348-3601 and we will send you complete information.

The Financial Press Does Investors No
Favors, Especially In This Kind Of Market

What has the financial press learned by going through the most recent market cycle?  Nothing.  The press has already forgotten the greed of 1998 to 1999, the fear of 2000 to 2002 and their poor financial advice to individual investors in both time frames.  Their mantra is still that individual investors can beat the markets on their own, rather than achieving a real rate of return consistently over time.  They advise moving from one hot investment to the next without looking back.  Or from one investment strategy to the next, regardless of whether or not most investors can really implement those strategies on their own.

And investors are hungry for ideas that sound good.  The three-year bear market that ended in 2003 dealt serious losses to most investors.  Based on mutual fund money flows, many investors bailed out of the market either partially or completely in late 2002 very near the bottom.

We also know from those same money flow numbers that most of the investors who bailed out near the bottom did not get back in to catch the huge recovery of apprx. 45% in the S&P500 Index from March 2003 to March 2004.   So they are very frustrated at this point, and this includes millions of Baby Boomers who don’t have that many more years to build their portfolios for retirement.  They are anxious to find something that works.

The Trading Range Market

Right now, the dilemma for investors is what to do in this sideways market we appear to be stuck in.  The sideways market is causing a lot of second-guessing on the part of the financial press and confusion on the part of investors who listen to them.

While the equity markets are under renewed pressure as this is written, the markets are pretty much where they started the year.  It appears we may be at the bottom of a trading range with the S&P 500 at around 1060.  The high side of the trading range appears to be around the 1160 mark.  Therefore, the S&P 500 is down about 9% off its high for this year.  Again, considering that the S&P 500 was up about 45% from its March 2003 low to its March 2004 high point, being down less than 10% from the peak doesn’t seem too bad to me. 

Of course, most investors don’t look at it that way.  They are very frustrated and eager to hear about any strategy that can work in a trading range market.  And the financial press has all kinds of  ideas, regardless of whether most investors can use them successfully or not.   Here are some examples.

Sector Rotation

In a July 16 “Managing Your Money” column in USA Today, an article dealt with how to play a sideways market.  One piece of advice was to target winning sectors.  Great advice!  All you have to do is just pick the winning sectors, ride them up until they are at a peak, and then sell them before they fall.  The problem is identifying these sectors before they get hot and in time to make a profit. 

There are some professional portfolio managers who track the market day-by-day and use the “sector rotation” strategy successfully.  Some of the professional Advisors we recommend use this strategy, but it is difficult even for them.  However, we’ve seen a lot of professional managers who were not successful (at least by our definition) in using sector rotation strategies, especially during the bear market.

If professionals struggle with identifying winning sectors, how many individuals looking at the market in their spare time can lock on to the sectors that are performing well in time to pick up significant gains?  Who is going to blow the whistle and tell them when to get out so they don’t ride those winning sectors down?  When was the last time someone in the financial press told you when it was time to sell something?  

Usually the press has moved onto the next hot investment for today and fail to follow up on the advice they gave yesterday.  After all, they are in the business of selling the latest news.   Yesterday’s hot investment or strategy is now old news. 

Traditional Market Timing

After decades of claiming that traditional market timing could not be done successfully, more and more pundits in the financial press are now recommending that individual investors try it in this sideways market.  As you well know, I believe market timing can be done successfully, but is best left to professionals.  But just as with sector rotation, we’ve found many more professional managers who don’t do well with market timing than those who have been very successful.  Very few can do it consistently over time, even with all the quantitative tools and research at their disposal. 

Timing isn’t something for most individual investors to attempt on their own.   They don’t have all the quantitative tools and research.  Even worse, most investors tend to be too emotional and can end up buying high and selling low.  This can be a disaster.  Yet the financial press makes it sound easy.

Buying Only The Best Stocks

Another piece of advice I read recently was to concentrate your portfolio by buying only the 10 stocks with the greatest potential for appreciation.  Can anyone reading this tell me which are the 10 best stocks to buy?  If you can, we need to talk!

This article assumed, apparently, that most investors know how to pick the 10 best stocks.  Just  identify the winners and invest only in them, it said, as if anyone can do it. 

If it were that easy, professional managers would never have any losers in their portfolios.  Do you really think a professional manager goes out purposely to buy stocks they expect to underperform?  If managers could identify those losers in advance with any certainty, they wouldn't buy them in the first place.  How much more difficult is it for amateurs to avoid losers while selecting the 10 best stocks?

Finally, if the people who write these articles could actually do what they suggest, do you think they would be working for columnist pay?  No!

Portfolio Rebalancing Not The Silver Bullet

In a July 28 column in the Wall Street Journal, an article dealt with how to make money whether the market goes up or down.  The article says that in reality you don’t need to guess the market’s direction in order to profit from shifting valuations.  All it takes, the writer says, is a little self-discipline.  Considering that it is very difficult to forecast the market’s short-term direction, all you have to do is annually rebalance your portfolio. 

Here’s how it’s supposed to work.  First, you initially construct a portfolio that is made up of the various asset classes, such as large company stocks, small company stocks, various bonds, real estate investment trusts, international stocks, etc.  Next, you determine the best weighting (allocation) to give each of these asset classes.   Then once a year, you sell the profits from your winners and use that money to buy more of your losers, to bring everything back into balance with your original allocation.  

The idea is to force self-discipline by buying into depressed sectors that may be due for a rebound, while lightening up on high-flying sectors that could be set to tumble.  It’s called portfolio rebalancing.

 I agree that it is important to diversify your portfolio with multiple asset classes and especially with different investment strategies.  And I agree that it is  a good idea to rebalance the portfolio periodically. 

The Hardest Part:
Deciding On The Investments

The problem I have with so many of these investment articles in the financial press is that they assume their readers already know how to allocate their portfolios; they know which asset classes are appropriate for them; and they know what percentages should be allocated to each asset class and/or strategy. 

Yet our many years of experience tells us just the opposite, that most investors don’t really know these things.  Most investors need a professional to help them with these decisions.  They need a professional financial plan designed specifically for their needs, risk tolerance and financial objectives.

I wish the press would stop telling individual investors that they can do all these complicated things on their own.  The press should be advising them to seek professional help in their investment selection and portfolio management.  It’s called financial planning. 

At ProFutures Investments, we provide comprehensive financial planning at no charge.  We have three Investor Representatives with years of financial planning experience, including one Certified Financial Planner.  At no cost or obligation, and based on the information you give us, we will do a full analysis of your investment portfolio, and we will give you a formal recommendation including any changes we would suggest.

As noted above, we do believe that diversification is very important - both in terms of asset classes AND strategies.  Where we differ from most financial planning firms is that, in addition to mutual fund portfolios, we also have specific managers that bring you different strategies such as sector rotation, market timing, etc.  While not suitable for everyone, most investors who come to us want to add these strategies and others to their portfolio.

If you would like to take advantage of the financial planning services we offer, you need only to give us a call at 800-348-3601 to get started.   There is never any pressure to invest in any of the services we offer.

At the end of July, the Commerce Department released its preliminary report on 2Q GDP, showing the economy expanded at an annual rate of 3.0%.  That was somewhat less than the average expectation of 3.5%.  On June 25, the government released its final report on 1Q gross domestic product.   In that report, they revised 1Q GDP growth down to 3.9% (annual rate) from 4.4% reported earlier.  That compared to growth of 4.1% in the 4Q of last year. 

Keep in mind that growth of 3.9% and 3.0% are both strong, but the reaction to the latest preliminary report for the 2Q was rather negative.  The media, of course, characterized the latest GDP report as very disappointing and a sign that the economic recovery is grinding to a halt.  Not so, as I will explain below.

The economic recovery has slowed modestly as indicated by several reports over the last several weeks.  Here's the rundown.  The Index of Leading Economic Indicators edged down 0.2% in June (latest data available), the first monthly decline since March 2003.  While some in the media made a big deal out of this, the LEI is still above where it was in the 1Q of this year.  We would have to see this index fall for three consecutive months to indicate that the economy is in any trouble.

Consumer spending slowed slightly in June with retail sales falling 1.1%.  Here, too, a modest decrease in one month does not suggest a trend.   Durable goods orders declined by 1.8% in May, and the media made a big deal about that, yet orders for non-durable goods rose by 1.5% the same month.  Durable goods orders rebounded, up 0.7%, in June.

The Institute for Supply Management's ISM Index fell from 65.2 to 59.9 in June, the lowest level since December.  The index had risen sharply for several months in a row, hitting a record high in April, so it is not unusual to see a pullback.  Keep in mind that any reading above 50 indicates that the economy is growing.  Here, too, we would have to see this index fall for three consecutive months to suggest that the economic recovery is stalling.

Not All Bad News

The media has a tendency to focus on the bad news.  Yet there have been several very positive reports over the last few weeks that you may not have heard about.  Perhaps the most encouraging is the Consumer Confidence Index which soared almost 9 points in June to 101.9, the highest level since June 2002.  Separately, the University of Michigan's consumer sentiment index also rose sharply in June.  The Consumer Confidence Index for July was released last week showing another jump of over 3 points to the highest level in two years.  This is important because consumer spending accounts for apprx. 70% of GDP.

Sales of existing homes hit a new record high of 6.95 million units in June, despite higher mortgage rates.  New home sales hit a record in May.  So, the housing market remains very robust even in the face of higher interest rates. 

While the media made a big deal out of the latest jobs report, there are indications that hiring will increase in the months ahead.  The Labor Department reported that 112,000 new jobs were created in June, versus 250,000 in May.  Even though the July unemployment number was very disappointing, over one million new jobs have been created this year, and there are indications that new job creation will increase in the months ahead. 

The National Association for Business Economics conducts a quarterly hiring survey of CEOs of major corporations.  In the latest survey, 41% of respondents said they plan to increase hiring versus only 34% in the last survey taken in March.  This suggests that the rate of new job creation will increase in the second half of this year.

Finally, the latest Wall Street Journal survey of economic forecasters is very encouraging.  The Journal surveyed 55 leading economists earlier this month, asking for their predictions on economic growth.  The average estimate is for GDP to grow by 4.4% in the 2Q and 3Q and 4.2% in the 4Q.  They also predict growth of 3.7% in the first half of 2005.

So The Economy Is Fine

Despite how the media and the gloom-and-doom crowd may spin it, the US economy remains on very firm ground.  Solid growth should continue through the end of this year and well into 2005, barring some major unexpected surprise. 

Obviously, if there is another major terrorist attack in the US, then we can throw these positive forecasts out the window.  As discussed further on pages 5 and 6, we have all heard the new terror warnings which were announced on August 1, complete with specific targets the terrorists may have (or had) in mind.  Unfortunately, it is impossible to know if these threats are real.  But other than this risk, the economy will continue to grow. 

The Impact Of High
Oil Prices On The Economy

As this is written, crude oil has just soared to a new record high above $44.50 per barrel.  Skyrocketing oil prices have obviously played a role in slowing the economy down somewhat, as discussed above, but not by nearly as much as the media and the Democrats would have us believe. 

With oil prices rising almost daily, we have seen the usual outpouring of pessimism from the gloom-and-doom crowd, the media and the Democrats.  The media and the Democrats would have us believe that the spike in gasoline prices is all the fault of George W. Bush and his former cronies in the oil business.  The truth is, US presidents have very little influence on oil prices, even if they resort to tapping the strategic oil reserve.

In their July issue, the editors at The Bank Credit Analyst offered the following analysis which suggests that high oil prices are not nearly as big a drag on the economy as the media and the Democrats would have us believe.  They say:

“High oil prices have caused problems in energy-intensive sectors of the economy. Nevertheless, prices have not been high enough to threaten the overall economic recovery. It is often pointed out that previous spikes in oil above $30 caused economic downturns. However, there are important differences between the current environment and other periods when oil prices rose sharply.

For example, in the previous episodes, the economic expansion was already at a very advanced stage. Monetary policy was tight with the yield curve either flat or inverted and the economy was running out of steam. Thus, oil prices moved up when the economy was already very vulnerable. The same point holds true whether one looks at indicators for the U.S. or the global economy.

It is also very important to remember that the U.S. and other major economies have become less sensitive to oil price movements over the years because of increased energy efficiency. This shows up in the steady decline in the amounts of energy and oil that are required to produce a dollar of GDP. The ratio of oil consumption to GDP has fallen by over 50% in the past 30 years.

The same picture is broadly true for other industrialized economies. The reduced sensitivity to oil is also highlighted by the fact that oil accounted for only 3% of consumer spending in the first quarter, compared to 4% at the time of the 1990 Gulf War and 6% two decades ago. Higher oil has taken a bite out of consumer spending power, but the effect has not been large. The bottom line is that as long as prices don’t keep rising, the impact on overall economic activity should be modest.

The impact of higher oil prices on consumers is probably more psychological than real. For example, there has been much talk about the effect of higher gasoline prices on summer vacation road trips. Yet, assuming a road trip of 1500 miles, the increased cost of a rise from $1.50 to $2.00 a gallon is only about $37. That hardly seems a vacation killer.

In a similar vein, the difference in the annual running costs between a family sedan and a SUV is only about $150 for each 50-cent increase in the gasoline price (assumes 11,000 miles a year). Rising gasoline prices perhaps have an exaggerated impact on confidence because it is a highly visible price and most drivers have to buy gas every week.”

In addition to concerns about the impact of high gasoline prices on consumer spending, there is also the valid concern about what soaring oil prices mean for inflation and thus, Fed monetary policy.  The editors at BCA address this concern as follows:

“This is where it is important to distinguish between relative and absolute price changes. If the Fed is maintaining a steady monetary policy, then a rise in the price of oil should not lead to a generalized inflation. In that sense, higher oil prices represent a relative price shock. However, if the Fed is more concerned with supporting growth than controlling inflation and accommodates the rise in oil prices, then the odds are good that the overall inflation rate will move higher.

The Fed made the mistake of accommodating  the early-1970s oil shock and this shows up in the strong pass-through from higher oil prices into core inflation. By the time of the second oil shock at the start of the 1980s, the Fed had just launched its major attack on inflation, but the new policy stance was still at too early a stage to prevent the surge in oil from feeding into overall prices. However, subsequent jumps in oil prices (1990 & 2000) had limited impact because of the Fed’s anti-inflation stance.

There could be a bit more of a passthough in the current cycle because the Fed is running a very accommodative policy. Core inflation has increased in recent months and higher energy prices may be partly responsible. Corporate pricing power has improved and companies will pass on the increased cost of oil if they are able. Nonetheless, the odds of a sustained acceleration in inflation are low.”

Where Oil Prices Go From Here

Over a year ago, when crude prices were trading near $25 per barrel, the editors at BCA predicted that prices would increase to a new trading range of $30-$35 dollars per barrel.  They accurately predicted the economic recovery and a surge in global energy demand.  Their forecast was right on track, as usual, except that oil prices are now considerably higher than they predicted.  On this, they say:

“It does not seem credible that supply and demand trends have changed enough since the  end of last year to warrant an almost $10 jump in prices. Indeed, the recent run-up in prices above $40 had all the classic hallmarks of a speculative overshoot... There will be some relief on the supply side with OPEC announcing that production will be raised by 2.5 million barrels a day. Modest increases in global oil output and a reduction in speculative activity should be enough to reduce prices to the low $30s.”

BCA’s analysis indicates that high oil prices are not nearly the drag on the economy that we are led to believe by the media.  BCA was careful not to speculate on how high oil might go before it peaks, or when it will peak, but they do not believe it will remain at current levels for an extended period of time.  We have to hope BCA is right on this one, that this is a speculative overshoot and that prices will fall back to the $30-$35 range before too long.