The government revised 2Q GDP growth from 2.8% to 3.3% (annual rate).  The latest Wall Street Journal survey of 55 leading economists had an average forecast of 3.6% growth in GDP in the 3Q and an average expectation of 4% for the 4Q.  While these numbers are good, the economy is still trying to recover from the “soft spot” we hit in the summer.  And record-high oil prices are not helping matters any.  While the economy is still very healthy, and a recession is not likely anytime soon, soaring oil prices will take a toll if they continue.

In that regard, we take a close look at what’s going on in the oil market today in this issue.  It seems everyone is a bull on oil these days.  The story is that supply can’t be increased fast enough, demand cannot slow down and prices must go even higher.  But Iwill tell you, this market has all the signs of a classic bull market blowoff that will end badly for the bulls, if history is any indication.  Read more on pages 4-5.

The stock markets declined for most of September with the Dow Jones dipping briefly below 10,000 at one point.  Icontinue to look for the stock markets to break out of the recent trading range to the upside, perhaps after the election.  With the economy expected to remain firm for the next year or so, stocks should benefit, especially if oil prices cool off.  Yet even though I am optimistic on stocks, most of my money is with professional Advisors who can “hedge” or go to cash if the market turns down in a meaningful way. 

Surprisingly, bonds have been a good place to be this year.  Long rates have actually fallen despite a strong economy and three short-term rate hikes by the Fed.  Investors are rushing back into bond funds again, but rates may be about as low as they’ll go and could turn up soon.  This may be a good time to look at Capital Management Group.

Finally, with the election just three weeks away, I give you my overall thoughts about this election season.  As this is written, the race is close once again.  I will vote for President Bush.  See page 8.

Introduction

The economy slowed marginally in August based on the latest reports, but GDP growth in the 3Q should still be a solid 3-3.5% (annual rate).  Early reports suggest that the economy advanced in September.  This month, we look at the latest numbers.  Crude oil prices topped $50 per barrel for the first time in history in late September and stand at a record $53 as this is written.  In this issue, we look at the reasons why oil just keeps going up. 

The Dow closed below 10,000 in late September but has rebounded somewhat as we go to press.  Are we in a bear market, or is this another good time to be buying?  Bonds have done surprisingly well of late, thus offering investors another chance to take some profits.  In the pages that follow, I offer my thoughts on how you should be investing in today's uncertain markets.

The Economy Slowed In August

The Commerce Department revised 2Q GDP from +2.8% to +3.3%.  Most economists still expect 3Q economic growth to be around 3½% in GDP.  The latest Wall Street Journal survey of 55 leading economists had an average forecast of 3.6% growth in GDP in the 3Q and an average expectation of 4% for the 4Q.  Yet if the economic reports for August are any indicator, we will be lucky if the economy makes those numbers.  Let’s take a look at the latest economic reports.

In perhaps the most troubling report, the Index of Leading Economic Indicators (LEI) fell 0.3% in August.  That marks the third consecutive monthly decline in the LEI.  Fortunately, the three monthly declines have been minimal.  This index bears watching closely.

The Conference Board reported that consumer confidence fell sharply in August (-7 points), but the University of Michigan’s consumer sentiment index fell only slightly in August.  On September 28, the Conference Board reported that consumer confidence fell slightly again last month.  Households surveyed by the Conference Board were most nervous about jobs and soaring gasoline prices.

Along the same line, retail sales eased 0.3% lower in August (latest data available) following a rise of 0.8% in July.  Back to school shopping was not as strong as expected.  Auto sales dropped sharply in August but then jumped by over 10% in September.  Keep in mind that consumer spending accounts for over two-thirds of GDP.

On the manufacturing side, the ISM Index fell for the third consecutive month in September to 58.5.  While any reading above 50 in the ISM Index indicates growth in the manufacturing sector, the decline over the last three months is not a good sign.  Industrial production fell 0.3% in August following a rise of 0.4% in July.  Orders for durable goods fell 0.5% in August following a gain of 1.8% in July.

But There Was Also Some Good News

The unemployment rate fell to 5.4%, the lowest level in three years.  Since August of last year, over 1.7 million new jobs have been created.  For all of 2004, economists now expect over 2 million new jobs will have been created.

Despite rising oil prices, consumer spending rose 1.1% in July and held steady again in August.  Advance estimates suggest that consumer spending increased in September, even though oil prices rose above $50 per barrel.  Retail industry groups expect a strong 4Q from consumers.

The ISM manufacturing jobs index rose to 58.1 in September, up from 55.7 in August.  The manufacturing sector is hiring aggressively to keep up with demand.

Construction spending rose 0.8% in August following the rise of 1.1% in July.   That puts construction spending at a record annual rate of $1.02 trillion.  (What, you didn’t hear that from the media?)

There was also very good news in the housing sector.  Housing starts rose 0.6% in August to a new high and are up 10.4% over August 2003.  New home sales jumped a whopping 9.4% in August to the highest level ever and way above expectations.

Economists Raise Estimates

The economy had a stronger than expected July, a slightly weaker than expected August and early reports suggest another rebound in September.  Despite the weaker performance in August, the Wall Street Journal reports that several of the economists it regularly surveys have increased their estimates of  4Q growth to 4-4.5%.

In summary, the economy remains on a solid growth track.  The economy grew at an annual rate of 4.2% in the 1Q and 3.3% in the 2Q.  If growth in the 3Q and 4Q turn out to be 3.5-4% (or better), that will be near a 4% rate for the year.

Despite what we hear from the Democrats and the media, 3-4% growth in GDP is very respectable.  Jobs growth is likely to surprise on the upside in the 4Q, with over 2 million new jobs expected for all of 2004.  The view that the economy is still on a solid growth track is also shared by The Bank Credit Analyst as you can read below.

BCA’s Latest Thinking

The BCA editors began their October report with a bit of caution but remain optimistic about the economy.  While they have been positive on the economy all year, they are a bit concerned that the equity markets have not performed better in this environment.  They also point to the fact that bonds have performed well recently.  They observe that in a normal growing economy, stocks would be doing better and bonds would be doing worse.  

Yet the editors also remind us that this economic environment is anything but “normal.”  This is still the post-9/11 world with many uncertainties.

The editors are concerned about $50 oil prices, and warn that high energy costs will be a “headwind” on the economy.  They continue to believe that oil prices will fall, but they do not speculate as to when.   

“Oil prices are overdue for a drop, but it is hard to estimate when this might occur... strongly rising global oil production holds out the hope that crude inventories will climb in the months ahead, a necessary condition for prices to fall.”

Despite concerns about oil prices and the performance of the equity markets, they still expect the economy to grow by at least 3-3.5% in the second half of the year.

“We have been leaning to the optimistic side with regard to the economy. Corporate finances are in good shape and there has been no evidence of financial stress in the consumer sector. Meanwhile, the liquidity environment [Fed monetary policy] has remained accommodative, despite this year’s Fed rate hikes...

We continue to believe that the foundations of the economy are solid. Corporate and consumer balance sheets are in good shape, and falling loan delinquency rates show that there are no problems in servicing current debt burdens. Meanwhile, it could be argued that real GDP growth of 3.3% in the second quarter was quite robust, given the rise in oil prices and the drag from a rising trade deficit.”

While the editors did remain positive on the economy in their October report, they do remind us that this is their most likely scenario and it could be in error if oil prices continue to soar or if there are any major negative surprises.

As I will discuss below, high oil prices are a problem for the economy, but not as big a problem as the media would have us believe. 

What’s Driving Oil Prices?

Oil prices have once again soared to new highs with crude trading above $53 per barrel as this is written, and as BCA points out, this is a headwind for the world economy.  The latest spike has been spurred by the string of hurricanes in the US, concerns about militant uprisings in Nigeria and supply security in Russia, Saudi Arabia and elsewhere.  The strain on the world supply system has left it more vulnerable to supply disruptions and increased the likelihood of price spikes.

The string of hurricanes temporarily slowed or halted oil production in the Gulf of Mexico and elsewhere.  The hurricanes have also slowed imports of oil at Texas and Louisiana ports where some of our largest refineries are located.  Several refineries are actually low on crude. 

As a result, President Bush is expected to authorize at least three releases of oil from the Strategic Petroleum Reserve (SPR) to affected refineries.  The Bush administration has never approved a full release from the SPR and has maintained that oil should only be released in the event of a national emergency.  However, because the oil refineries’ requests amount to a temporary partial release, to be repaid in full, we are told that President Bush has, or will, grant the requests.

While the disruptions from the hurricanes may be only temporary, and while oil prices may dip back to $40 or lower afterward, the supply/demand fundamentals for oil continue to suggest the days of cheap oil are over.  World oil demand is growing at the fastest pace in 24 years. China’s economic juggernaut is draining oil from all around the world.  Chinese crude imports are up 40% so far this year and are forecast to keep rising next year as car ownership surges and power generation needs grow.  The US economy remains strong as discussed above, and we continue to consume apprx. 25% of all world oil production.  Demand from India, Asia and other regions also remains very strong.

On the supply side, new oil reserves are becoming harder to find and more expensive to develop. Many of the oil provinces outside OPEC are mature, which means that new finds are smaller, need more costly technology to develop and fall faster from peak production.

OPEC, which holds around two-thirds of the world’s oil reserves, has pushed its production to the highest level in 25 years in an effort to keep prices under control.  Most OPEC members are already producing flat out to meet demand.  This has left little spare capacity except for Saudi Arabia. 

The Saudis announced in September that they would increase production by 1½ million barrels per day to the level of 11 million barrels daily.  Yet even with this announcement, oil prices are trading near $53 per barrel as this is written. 

Iraqi exports have been repeatedly hit by sabotage attacks, keeping its supplies below pre-war volumes.  There are growing fears that Islamic militants may be planning attacks on oil facilities in Saudi Arabia.  Should that happen, oil prices would shoot higher once again.  Supply concerns have spurred many countries to increase strategic inventories, thus withdrawing more supply from an already tight market.

In the US, environmental concerns have prevented development of known reserves.  In addition, environmental regulations have resulted in significantly higher refining costs by forcing companies to build expensive new facilities and making it harder to ship supplies between regions.  As a result, US refining capacity has not kept pace with demand.

All of this points to continued high oil and gasoline prices.  The question is, should oil prices be above $50 per barrel or below $40?  The answer is, if we continue to see supply disruptions, then we may have to get used to $50 (or higher) oil prices.  On the other hand, if the supply chain can get back to normal, then I would expect to see oil prices retreat to the $35-$40 range. 

Don’t forget that oil is still a commodity, and in commodities, what goes up also comes down.  The latest surge in oil prices is fueled largely by aggressive speculation.  Bullish consensus is sky-high. 

Ever since I got into the commodity business almost 30 years ago, the biggest bull markets always reached a point where traders concluded that production can’t be increased and demand can’t be decreased.   That’s where we are today with oil.  The bulls believe it’s a no-brainer that oil has to go even higher.  That’s how it is at major market tops.

But believe me, production can always increase, at some price, and demand can always decrease.

While no one can predict exactly how high oil will go, this market will fall very hard whenever it peaks, and much of the long open interest (ie - the speculators) will be liquidated.

The Effects Of High Oil
 Prices On The Economy

Everyone agrees that high oil prices are a drag on the economy in several ways.  In addition to fuel, crude oil is used in thousands of other products that we all use.  As the price for oil rises, the prices for many consumer goods also go up.

Yet the economy continues to grow at a solid pace as discussed above, even though oil has risen from $30 to above $50 a barrel since the first of the year.  Had you told analysts on January 1st that oil prices would be $40 by mid-year and $50 in September, many would have predicted a recession.   While high oil prices are a drag on the economy, the effect on the economy is not nearly as great as it was  20 or 30 years ago.

Economists believe that because the US economy has transformed into a largely “services” economy, we are not as negatively impacted by a rise in oil prices as in the past. 

Economists also argue that if oil prices had merely kept pace with inflation since 1970, crude oil would be at around $95 per barrel today.  This is another reason they say we can have economic growth even with oil at $50 per barrel.

Most economists believe that for every $10 rise in the price of oil, economic growth slows by apprx. one-half of one percent.  On that basis with oil having risen $20 this year, economists say we should shave 1% off of GDP.  While this may be true, Itend to think it is a little conservative.  If oil prices were to stabilize at $50 or higher, Ibelieve we would see more than a 1% reduction in GDP growth.  But then, I’m not an economist.

Numerous analysts and economists have tried to estimate how much more the average family will have to spend for gasoline at today’s oil prices.  I’ve seen various estimates with each using different assumptions and with each posted before oil hit $53.  In general, for an average family with two cars that drives 20,000-25,000 miles per year, most estimates are they will spend an extra $800-$1,000 on gasoline at today’s prices.  And today’s prices for gasoline are likely to rise in the week’s jut ahead as gas prices catch up with the latest new rise in oil to above $53 per barrel.

The costs for home heating oil and natural gas are also rising significantly.   In the airline industry, jet fuel prices are up apprx. 40% this year.   Yet according to reports I’ve seen, plane tickets are flat to down slightly for the year.  These higher costs will get passed on to consumers at some point.

The bottom line is that the economy can continue to grow, but the longer oil prices stay at these levels, the more it will reduce consumer spending and therefore slow the economy.

Another Buying Opportunity In Stocks

Concerns about rising oil prices have pushed stocks back to the lower end of the trading range.  In late September, the Dow Jones dipped briefly below the 10,000 mark.  As this is written, the Dow  has recovered to 10,200.  The major stock market averages have been in a trading range all year with the Dow meandering between 9,800 on the downside and 10,600 on the upside.

I have money with one particularly savvy equity options trader in New York who just loves this kind of market.   He sells options on both sides of the market and hopes it stays in a trading range.  If it does, he gets to keep the option premiums paid by the buyers.  So far, he’s having a banner year while most equity managers and investors are struggling to stay even or are losing money.

Of course, selling options on stock indices is a very high-risk strategy, and I would never recommend that investors try to do this on their own.  In fact, I don't even recommend that investors purchase options since the vast majority of options (90% or more according to some sources) expire worthless - meaning the buyers lost ALL of the money they invested.

At this point, it remains to be seen if stocks will: 1) remain in a trading range; 2) breakout to the upside; or 3) breakout to the downside.  I continue to be on the optimistic side as I have been since just before we went to war in Iraq.  I base that opinion on the outlook for a continued strong economy for the next year or so and the improvement in corporate earnings and business spending.  Corporate profits are expected to have risen over 14% for the current quarter.

Another thing I like is the fact that “investor sentiment” has plunged to the lowest level in almost two years.  Over 60% of investors are bearish at this point according to several groups who track sentiment and “contrary opinion.”

Likewise, the number of bullish Advisors (professional money managers) has plunged to the lowest level in two years as well.  Equities tend to reverse higher when too many people turn bearish and reverse down when too many people turn bullish.  People are too bullish at the tops and too bearish at the bottoms.

While I have been bullish on stocks since just before the war in Iraq, I continue to have the bulk of my equity portfolio with active professional managers that have the ability to “hedge” their positions or move partially or fully to cash. 

Two excellent managers that can do this are Niemann Capital Management and Potomac Fund Management.  You can see their long-term performance records at my website www.profutures.com or you can call us at 800-348-3601.  Niemann requires $100,000 to invest in their programs; Potomac accepts accounts as small as $25,000.  I highly recommend both.  Past results are not necessarily indicative of future results.

Interest Rates - Bonds Do Well, But.…

Bond investors have enjoyed a nice surprise over the last few months.  Despite concerns about rising inflation and despite three Fed rate hikes this year, Treasury bonds and notes have performed well since June.  The 10-year T-Note, for example, has dipped slightly below 4% as this is written, down from near 5% in May and early June.  The 30-year T-bond has fallen to a yield of 4.7% as this is written, down from 5.7% earlier this year.

The question now is, how much lower can long rates go?  Will they match their historic lows reached in mid-2003 when the 10-year note fell to 3½% and the 30-year bond fell to near 4¼%?  I don't think so.  Unless there is a major negative surprise to the economy, I would expect we are near the lows in long rates now.  In fact, some professional bond managers are using this opportunity to take some profits and move to the sidelines or to other types of bonds.

For investors who are knowledgeable about the high yield bond market, now may be a good time to take some profits in traditional bond holdings and look to the world of junk bonds.  High yield bonds have the potential to appreciate when the economy is growing and in spite of a rising interest rate environment.  High yield bonds were the big winner in 2003 but have not yet moved that much this year.

I continue to recommend Capital Management Group for high yield bonds.   You can see their long-term performance record at my website www.profutures.com or you can call us for information. 

CMG invests in large, highly diversified high yield bond mutual funds.  Because these large funds are so diversified, and own so many different issues of high yield bonds, that greatly reduces the default risk that is associated with junk bonds.

CMG can be fully invested, partially invested or fully in cash depending on what their sophisticated systems are signaling about interest rate trends. 

I realize that high yield bonds are not suitable for some investors.  I do not recommend that investors get into this market on their own.  Even I don’t do it on my own; I only do it under the guidance of a proven professional bond manager like CMG.  Past results are not necessarily indicative of future results.

Conclusions

The economy should average 3-4% growth in GDP for the second half of the year.  The Bank Credit Analyst and most economists expect growth of 4% or better in 2005.  However, if oil prices remain in the high $40s or low $50s, this will present a serious headwind to the economy.

Regarding oil, there is an old saying in the commodity markets: “the solution to high prices is high prices.”  What this means is that the longer prices remain high, the lower they will fall eventually.  High prices lead to higher supply, reduced growth in demand and lower prices eventually.  In the case of oil, the bulls tell us there’s no way to significantly increase production, and China will cause demand to continue to soar.  But do not forget that oil is still a commodity, and commodities have a history of topping out when it's least expected.

If the economy continues to grow at 3-4% or better as expected, I believe that provides a window of opportunity for stocks over the next six months to a year.  I look for stocks to break out of the trading range to the upside later this year, perhaps after the election.  I think stocks could surprise on the upside yet again if there are no major negative shocks.

Yet I also recognize that I could be wrong.  Despite the firm economy and improving corporate profits, it is possible that this seeming national malaise could, due to an absence of buying, send stocks even lower.  That is precisely why the bulk of my equity portfolio is actively managed by proven professionals who can “hedge” their positions or move partially or fully to cash if need be.  The same goes for most of my bond portfolio.

If I am correct and stocks do trend higher, most investors will miss the move.  There is still a mountain of cash sitting on the sidelines in money market funds and CDs.  These investors are not buying stocks today.  And they will probably be too scared to get in when (and if) it becomes clear that the trend has turned higher.

That is why having professional active managers makes so much sense.  Successful money managers have systems in place which are designed to get them in the market if the trend turns higher, in some cases even before the trend turns clearly higher.  Just as important, those same systems are designed to signal them to hedge their positions or move to cash if the markets should roll over to the downside. 

By the time the November issue of Forecasts &Trends arrives, we will already know who will be the  President come next January, that is if we don’t have another contested election.  So here are my thoughts with three weeks to go.

First, I think it is sad that the country is so polarized.  There are people who will vote for anyone other than Bush, no matter what.  Many people would vote for Kerry even if he promised to double taxes and cut the military in half.  Likewise, there are people who will vote for Bush regardless of where he stands on the issues, because they despise Kerry and the Democrats.

Second, because of this great divide, the campaigns have become so vile and vicious, with both candidates essentially running attack and smear campaigns.   Both the Bush and Kerry campaigns have seized on each other’s messages and distorted them to the point that most undecided voters don’t know what to believe.  Frankly, it’s disgusting.

Third, the media have also stooped to new lows in their efforts to help bring Bush down.  The CBS/Dan Rather report on Bush’s National Guard service, complete with forged support documents, has to take the prize for scummy journalism.  But it’s not just CBS; ABC, NBC, CNN and others are almost as bad.  You should regularly visit one of my favorite websites, the Media Research Center at www.mediaresearch.org.  Each day, the folks at MRC chronical the liberal bias in the media.  You’ll be surprised how widespread it is.

Fourth, so much for campaign finance reform.  When Bush signed the Bipartisan Campaign Finance Reform Act in 2002, we were promised that  there would be no more “soft money” in political campaigns.  Political Action Committees (PACs), we were told, would pretty much wither away.  I remember at the time wondering why the Democrats and the media were so enthusiastic about the campaign finance bill back then.  Now we know.  They knew that Section 527 organizations would take the place of PACs in the 2004 presidential election.  That was an understatement!

The non-profit 527 groups have raised and spent hundreds of millions of dollars, most of it from Democrat-leaning groups for Kerry.  While I defend free speech, these 527 groups have served to polarize the electorate even more.  Several of these groups are controlled by liberal billionaires like George Soros who are spending tens of millions of their own money in their efforts to defeat George W. Bush.  While I defend their right to do so, this is just another reflection of how divided our nation is.

It will come as no surprise to most of you that I will vote for President Bush in November.  Bush has done a number of things for which I have criticized him (steel tariffs, the farm bill, big spending, etc.), but would I vote for the most liberal member of the Senate?  NO, especially not in the post-9/11 world we live in.  I am a big supporter of Bush when it comes to continuing the War On Terror and national security.  I don’t know what John Kerry would do on these issues.  He’s changed his positions so often,  I don’t know if he even knows for sure or not.

But can Bush hang on and win this thing?  Iwish I knew!  Bush blew a significant lead in the polls and in the electoral vote with his disappointing first debate with Kerry.  Now the race is close again, at least in the national polls.  Bush has two more debates.  Let’s hope he does well.  And let’s hope that most swing voters decide to trust Bush over Kerry to continue the War On Terror.