The US economy just keeps lumbering ahead.  As the monthly reports roll in, we see some good ones and some disappointing ones, but mostly positive ones.  The debate over whether it’s a 4% growth economy or a 3% growth economy misses the point.  The US economy is expanding and is likely to continue to do so for at least the next few years.  No recession is in sight at this time.  That could change, of course, but probably not anytime soon unless some very negative surprise occurs.

In case you haven’t noticed, the Dow and the S&P500 have managed to move back up to near their all-time highs, even though hundreds of billions of dollars of capital are still sitting on the sidelines.  I have been positive on the stock markets for the last two years, although I have had some doubts in the last couple of months, largely due to BCA’s concerns.   But if stocks break out to new highs in the next few weeks, we could see another buying frenzy if the mountain of cash on the sidelines decides to come in.

In this issue, I summarize for you a surprising new long-term forecast from The Bank Credit Analyst.  In short, BCA now predicts that the US economy will enjoy another decade of surprising growth with modest interest rates and inflation, and that the gloom-and-doom crowd will be wrong for yet another 10-15 years.  BCA does not believe we will hit the debt wall for at least another decade.  Surprised?  So am I.

BCA also predicts that the stock markets will deliver annual average returns of only 6-7% over the next decade, with continued high volatility .  BCA also predicts that bonds will deliver disappointing returns over the next decade.  If they are correct, as they usually are, this will be disappointing news to most Baby Boomers as well as many senior citizens already in retirement. 

BCA recommends that investors embrace market timing strategies, sector rotation strategies and other “active management” strategies if they are to achieve their investment goals and retirement goals over the next 10-15 years.  As you know, most of the professional money managers we recommend employ these active management strategies.

Introduction

The Bank Credit Analyst is one of the most respected and widely followed forecasting groups in the world.  They forecast trends in the US economy (and other major economies around the world), trends in interest rates, inflation, the stock markets, bonds, currencies, oil, gold and at times, the major commodities markets. 

BCA’s services are quite expensive.  Their original flagship monthly publication, The Bank Credit Analyst, with 40-50 pages of information, costs over $1,100 a year, and they have a myriad of other advisory services that cost in the tens of thousands a year.  Yet institutional investors, banks and brokers, family offices and high net worth individuals all over the world are all too happy to pay it.  Why?   Because BCA is the most accurate forecasting group I have ever seen.    That’s why I've been a continuous subscriber since 1977.

In their latest issue, BCA predicts that the US economy is likely to remain generally strong until 2015-2020.  Wow!  If they are correct as they usually are, the gloom-and-doom crowd is going to be wrong for another decade at least.  In the pages that follow, I will summarize their latest long-term forecast and what you should be doing about it.

Another Decade Of Growth

In the mid-1990s, BCA published a series of articles arguing that the US had embarked on a technology-driven “long wave” that would be very bullish for economic growth and the equity markets for at least a decade.  Their forecast was very controversial at the time (even I doubted it at first), but the equity markets soon exploded in the greatest bull market of all time.

The US economy has enjoyed very strong growth over the last decade.  The recession in 2000-2001 was the mildest on record.  And GDP growth has been very strong since, with the exception of the first few months after 9/11.  Now BCA predicts that the economy will continue to be generally strong for another decade or longer.

Let me be clear.  The “long wave” upturn does not imply that there will be no recessions along the way.  Rather it implies that the economy will tend to be stronger than expected and recessions will be milder and shorter than expected.

This latest forecast from BCA will no doubt be just as controversial as the first one in the mid-1990s if not more so, because concerns are currently very high over the issues of Social Security and Medicare, high budget and trade deficits, the falling dollar and record levels of consumer debt.  So it will be interesting to see the reactions to BCA’s latest eye-popping forecast in the financial media.

The Basis For BCA's Forecast

At its core, BCA’s bullish long wave forecast is based on the assumption that the Information Technology (IT) revolution still has a long way to go.  They compare the IT revolution to that of the railroad in the mid-to-late 19th century and the automobile in the 20th century.  There is no question that the IT revolution has led to population shifts, new ways of doing business, new innovations and skyrocketing productivity.  The "Information Age."

Legendary business writer Peter Drucker believes that the IT revolution is a massive, decades- long transformation of society to the point where knowledge - rather than land, labor or capital - becomes the basic economic resource or means of production.  Drucker postulates that the transformation to a knowledge-based society may not be fully complete until 2010-2020.

Like Drucker, BCA believes that there are still substantial innovations and monumental developments to come from the IT revolution over the coming decade that will continue to increase productivity and result in better standards of living.  Some of these developments that will fuel the economy are difficult to envision today, especially in such areas as biotechnology and nanotechnology. 

A survey conducted by the Institute of Supply Management (ISM) in late 2003, for example, found that most companies believed they were only in the very early stages of capturing the gains and benefits from the Internet.

BCA also points out what is widely known in the IT industry: Computing power continues to grow at an exponential rate, and the ability to process information ever more rapidly affects productivity and innovation across the economic spectrum.

Another requirement for the long wave upturn to continue is a trend toward rising world trade.  Trade expanded strongly in the 1990s and so far this decade largely because free-market economics has spread around the world, especially in Asia.  BCA states:

“The continued rapid development of China, India and other emerging economies suggests that world trade will continue to expand at a healthy pace for the foreseeable future, further supporting the case for a long wave upturn.  While many see the growth of emerging Asia as a threat, the reality is that most countries will benefit from rising trade and prosperity.”

In summary (and this is indeed a brief summary), BCA believes that the US economy will continue to surprise on the upside for at least another decade, led by the continued advancement of the IT revolution which affects all economic sectors.  Recessions should be generally mild and relatively brief.  They also believe that interest rates and inflation will remain relatively low throughout the next decade.

What Could Derail BCA’s Forecast?

As with all forecasts since 9/11, there is the terror threat.  If there are more major terror attacks in the US, then all bets are off.  The good news is that all of the intelligence services I read seem to believe that we’ve made great strides in disrupting al Qaeda and other terror groups around the world.  Let’s hope and pray they are correct.

Then there’s the whole Social Security/ Medicare issue.  Obviously BCA is in the camp of those who believe that the financial crises when these entitlement programs go bankrupt will not occur until sometime after 2015. 

This assumption may in fact be correct, but I have to tell you that I believe, and have believed for many years, that these programs will be causing some serious economic and financial problems before 2015.  It remains to be seen if I am correct, but it is probably safe to assume those problems are at least five years out.

BCA actually believes that the biggest threat to their long wave forecast is the government.  They point out that the worst recessions in the last century and the Great Depression were largely the result of major policy errors by the US government.

The worst recessions were caused by overly tight monetary policies and high interest rates, and in the case of the Depression, by protectionist trade policies (Smoot-Hawley Tariff Act of 1930).  Hopefully, our policymakers have learned from these mistakes in the past.

The next worry BCA has is if the bubble in the housing market were to burst.   If home prices were to decline significantly, this would definitely alter their forecast.  While they certainly cannot rule out a bursting of the housing bubble, they point out that this would most likely happen in a serious recession, and they don’t see one on the horizon for the next decade in their “most likely scenario.”

BCA’s Long-term Forecast For Stocks

BCA believes that the US equity markets will benefit from the long wave economic upturn over the next decade.  However, their forecast will certainly disappoint many, especially those who are behind in their retirement savings.  BCA predicts that equity returns will average only 6-7% over the next decade, assuming the long wave upturn remains intact.  

The next question is, if the economy is going to be stronger than expected, then why would equities not at least perform up to their long-term historical averages (10% or better)?  One of the main reasons for this is the fact that stocks (especially tech stocks) got so wildly over-valued in the late 1990s bubble, and many stocks are still pricey, even at current levels, based on P/E ratios and other measures.  Thus, equity returns will likely be muted to some extent over the next decade according to BCA.

BCA’s forecast of 6-7% average annual returns in equities over the next decade is consistent with that of other credible sources I read (and I don't mean the cheerleaders on Wall Street) as well as  legendary investment mogul Warren Buffet.  BCA says:

“With 10-year Treasury yields now down near 4%, the prospect for future [bond] returns is not very inspiring, although they should still be positive in real terms. Although future [bond] returns will be modest by historical standards, average equity returns should outperform bonds going forward, consistent with a long-wave expansion. Specifically, it is reasonable to expect equities to deliver average returns of less than 7% a year over the next decade, assuming growth of around 5% a year in earnings, a dividend yield below 2%, and no change in valuations.”

BCA maintains that while equity returns are likely to be in the 6-7% range over the next decade, overall market volatility will remain high.  Read differently: returns will be muted (6-7%) while downside volatility will remain relatively high.  That means that periodic drops of 10-15% or more will occur along the way over the next decade.

BCA Again Recommends “Market Timing”

Given that stock market returns are expected to average only 6-7% over the next decade, the editors at BCA once again recommend that subscribers consider active management strategies including traditional market timing and sector rotation.  They say:

“As we have discussed at length in the past, equity returns are likely to be modest on average during the next decade or so.  This means that market timing will assume more importance, as will stock and sector selection.”  [Emphasis added, GH]

BCA first began recommending market timing strategies in late 2003 because they expected the stock markets to be choppy in 2004.  Admittedly, most investors are not very successful in timing the equity markets or mutual funds on their own, so I don’t recommend that you try it.

The same is true of sector rotation strategies.  Most investors don’t do well trying to anticipate what will be the next hot sectors.  Often, they move to a hot sector just before it falls out of favor.  So, here too, I don’t recommend you try sector rotation on your own.

However, there are some outstanding professional money managers that employ traditional market timing strategies (the legal ones, by the way) and sector rotation strategies.  Most of the professional money managers I recommend use one or both of these active management strategies.  

BCA’s Forecast For Bonds

BCA believes that interest rates and inflation will both remain relatively low over the next decade.  As such, they do not believe that bonds have a lot of upside potential in the next few years.  They expect T-bond returns to be only in the 4% range or so.  As a result, they continue to recommend below average holding in T-bonds and other corporate bonds.  On the other hand, if the economy is going to remain strong, then there should be several good cycles in high yield bonds over the next decade.  This is good news for Capital Management Group and its high yield bond strategy. 

Some Fundamental Questions For All Of Us

If BCA’s forecast is generally correct, as it usually is, then we come to a set of three fundamental questions (at least for serious readers).

First question: Can you reach your retirement goals if stocks return only 6-7% over the next decade?  I suspect that most Baby Boomers cannot.   Many retirees won't be able to make it either. 

Second question: What are you going to do about it if 6-7% returns won't get you to where you need to be?  Do you stick with Wall Street’s “buy-and-hold” mantra, and hope the stock market does better than BCA’s forecast? 

Third question, and the hardest one: What if BCA is wrong and the stock markets don't even deliver 6-7% returns?  BCA can be wrong, of course.  Unexpected negative surprises could occur.  Stock market returns could well be lower. 

And then we come to yet a fourth and final question: What are you going to do if stocks don't go meaningfully higher over the next decade?  Do you concede that your future is largely uncontrollable, subject to the whims of the market?  Do you simply accept the fact that the stock market gives whatever it gives, and you have to take the risk of 20-30% or higher losses from time to time?  I hope not!

There Is A Better Way, In My Opinion

If you have been reading this newsletter for long, you know that I believe that most investors would achieve better returns by using successful professional money managers to direct a significant part of their portfolios.   While past results are no guarantee of future results, the professional money managers I recommend would have given you better “risk-adjusted” returns than a buy-and-hold strategy, especially during the last few difficult years.

Better “risk-adjusted” returns, or “absolute returns” (the more recent jargon) means that you earn a decent return, based on market conditions, without enduring the periodic bone-jarring losses that periodically occur in the stock markets.  The S&P 500 plunged over 44% in the bear market of 2000-2002.

How do the professional money managers I recommend do that?  Simply put, most of the money managers I recommend use strategies to get them out of the market, or “hedge” their positions, during significant market downturns, and they have done so successfully for many years.   Again, past performance is no guarantee of future results.

As noted above, most of the professional money managers I recommend use market timing strategies or sector rotation strategies or both.

Maybe it’s time you more seriously consider adding such “active management” strategies to your portfolio, especially if BCA is correct that stock market returns will be only 6-7% over the next decade, and especially if you need more than that to meet you retirement goals.

Conclusions - Think About It

The Bank Credit Analyst, my best source ever, has some good and bad news (sort of).  The good news is, they believe the US economy will continue to grow for the next decade or longer with no serious recessions, barring some very negative surprises.  The bad news (sort of) is that they expect the stock markets to gain only 6-7% on average over the same decade at best.

6-7% does not get most Baby Boomers where they need to be over the next 10 years in terms of retirement.  It also does not assure most current retirees the lifestyle they hope to enjoy.  And there is no guarantee that 6-7% average annual returns in equities will actually happen.  Returns could be less.

Do you bet your future on Wall Street’s “buy-and-hold” strategy - or what we call “buy-and-HOPE” strategy?  Or do you open your eyes, expand your horizons and consider professional managers who employ “active” strategies that can get out of the market (partially or fully) and/or hedge their positions to avoid the huge losses when the markets go down? Obviously, I recommend the latter, especially if equity returns will be muted, while market volatility is likely to remain high.

Many people who read this newsletter and my weekly E-Letters have already placed money with the professional money managers we recommend.  But many more have not.  My theory is that it’s because you live in other areas of the country and feel that you need a financial/investment advisor close by.

That’s fine if you feel that way, but we have clients all across America, many of whom I have never met.  Distance and the lack of a personal face-to-face should not be a reason to stay in a “buy-and-hope” strategy that your local stock broker recommends.

If BCA is remotely correct, the most likely scenario is that you will earn 6-7% returns in your buy-and-hope equity portfolio over the next decade, with some gut-wrenching declines along the way.  That is not acceptable to me, and I don't think it should be acceptable to you either.  It very likely won’t get you to where you need to be.

If you don’t want to be entirely dependent on Wall Street’s buy-and hope strategy, then I suggest you consider the active management strategies I recommend.  Have the confidence of knowing that a part of your portfolio is managed by professionals that can get out of the market or “hedge” their positions in a major downturn.  If returns are only going to be 6-7% on average, then it is more important than ever to avoid the big drawdowns in the market.

Don’t worry that we are in Texas and you are on the East Coast or West Coast, or somewhere in between.  We have clients that have been with us for 10-15 years or more that we have never met, but we have a close relationship via the phone and e-mail.

The bottom line is, stock market returns may very well be disappointing for the next decade or longer as BCA contends.  The key to success, if they are correct, is to avoid the big losses along the way.  The best way to do that, in my opinion, is to use professionals who employ “active management” strategies which have the flexibility to get out of the market or hedge their positions during market downturns.

New Advisors Added To The Team

Last month I introduced you to Third Day Advisors, a money manager with an outstanding performance record using a long and short strategy in mutual funds.  Since Third Day is the only manager we recommend that will actually take a net-short position in the market, I expected we would have a large response from clients and prospective clients.   I was correct - we’ve had over 200 requests for information on Third Day!

If you have not looked at Third Day Advisors, I highly recommend you do so, if a long and short program is suitable for you.

Next month, I will introduce you to another new Advisor we have found.  This new Advisor has arguably an even better performance record than Third Day, although his program does not short the market.  You can decide for yourself next month.

You can look at the professional money managers I recommend by going to my website www.profutures.com .  But you would be better served by calling us at 800-348-3601 and speaking to one of my Investor Representatives who are non-commissioned, nice guys who can help you get started, rather than cruise our website on your own.

During his re-election campaign, President Bush piqued interest among voters, especially conservatives, when he said that replacing the current income tax code with a national sales tax was “an interesting idea.” Then just after the election, he signaled that tax reform would be a centerpiece of his domestic agenda, and made a pledge to name a bipartisan panel to draft a fundamental tax reform proposal.  That sent conservatives scurrying into either the flat tax or national sales tax camps to muster political momentum.

Shortly thereafter, White House spokeswoman Clare Buchan said, “The president believes the tax code should be simpler, fairer, and more conducive to economic growth and he looks forward to appointing an advisory panel to review options for reforming the tax code.”

A nine-member, bipartisan “Advisory Panel on Federal Tax Reform” was named in January to study options to “simplify” the nation’s tax system.   Heading the panel are former Senators Connie Mack (R-FL) and John Breaux (D-LA). Both served on the Senate Finance Committee, the panel that acts as the nation’s gatekeeper on all tax legislation.  The panel   has its own website http://www.tax reform panel.gov/ if you care to check it out.

President Bush is said to have told the panel members to “be bold” in their thinking about tax reform.  While all this sounds good, the Bush administration has already begun dialing back expectations that they will move to scrap the current graduated income tax for another system.  At this point, it does not appear likely that a flat tax, a national sales tax or a value-added tax are even on the table.  This is disappointing.

What now appears most likely is that the tax panel will look to simplify the current income tax system and cut or eliminate taxes on saving and investment.  While any simplification of the draconian tax code is welcomed, and while lowering taxes on savings and investment is a good idea, Bush’s tax reform proposals are likely to be disappointing to most conservatives who want to see the current system scrapped.

Broadening The Tax Base

In his State of the Union address in January, President Bush said he would reform the tax code so that it is “pro-growth, easy to understand and fair to all.”  Sounds good.  The current tax code is so complicated that an alarming number of taxpayers are under-reporting their income or are not filing tax returns at all.  Experts estimate that uncollected taxes will hit $400 billion in 2005, up from $311 billion for 2004 and $127 billion for 1998.

President Bush has said that one of his main objectives is to broaden the tax base by simplifying the system to get the under-reporters and the non-filers to pay their fair share.  In order to do this, you have to devise a tax system that captures the tax revenues from the vast underground economy, criminals and illegal aliens who do not report income.  I would argue that simplifying the current ponderous tax code will NOT be enough to entice those who are under-reporting or not paying taxes at all to pay their fair share.

Proponents of a lower flat tax on all income, with little or no deductions, believe such a system would go a long way toward capturing tax revenues from the underground and non-filers.  But you have to wonder if these people would step up to the table just because the system is vastly simpler.

If we really want to reform the system to significantly broaden the tax base, then we should be looking at a national sales tax (also called a consumption tax) or a value-added tax, which automatically affects everyone at the cash register.

But according to everything I have read in the last few weeks, neither the sales tax nor the value-added tax is on the table for the panel.  Ditto for the flat tax.  While President Bush may personally favor some of these plans, White House insiders have intimated that he does not believe he could get such a radical change through Congress.  No doubt it would be a major political battle, but that does not mean he shouldn’t try.

The current voluminous tax code and the IRS are almost universally disliked by the public.  The current tax code consists of several million words on over 17,000 pages.  It includes many perplexing rules and is riddled with “special interest” provisions.  Former deputy Treasury Secretary Samuel Bodman estimated that Americans collectively spend   "six billion hours a year" in deciphering the rules and filling out their tax returns.  Considering there are apprx. 131 million individual tax returns, that equates to 45 hours each.  Bodman estimates the cost of doing this at $120 billion per year.  An estimated 75 million individual taxpayers (57%) pay accounting firms to prepare their income tax returns for them each year.

Imagine the huge public support President Bush would enjoy if he embraced a national sales tax or a value-added tax, or even a flat tax that either eliminated the need to file tax returns or dramatically simplified them.  I think it could happen if Bush would push for it!  But these ideas - which can work, by the way - are apparently off the table.

Instead, the Bush administration is pushing for major amendments that would shield interest, dividends and capitals gains from taxation, expand tax breaks for business investment and take other steps intended to simplify the system and encourage economic growth.  The administration is also pushing hard for large tax-deferred savings accounts that could shelter thousands of dollars of deposits each year from taxation on interest and investment gains, according to White House economic advisers who have been involved with the planning.  Also, they would eliminate the “alternative minimum tax,” a parallel income tax designed to ensure that the rich pay income taxes, but one that increasingly ensnares the middle class.  The president also said in December that he wants to see the estate tax repealed.  Bush has also said he wants to maintain the deductibility of mortgage interest and charitable donations.

These ideas sound good - if we can’t get a flat tax or a sales tax - but there are two major problems.  First, to pay for it, the Bush plan would eliminate deductions for state and local taxes.  That won’t fly.   Second, there is virtually no way to get these measures passed in Congress. 

In the end, they will just tinker with the margins and we are not likely to see real, meaningful tax reform.  I hope I am wrong.  Our one hope is that the House of Representatives beats the president to the punch on tax reform.  Congressman John Linder (R-GA), who favors a national sales tax, said last week that the House Ways and Means Committee may begin hearings as early as March on tax reform.    He hopes to have a tax reform plan by August.  Let’s hope the House goes for a flat tax or a sales tax, but I am not optimistic.

Needless to say, tax reform is one more issue on which I am disappointed in President Bush.  He should have pushed harder for a simpler and fairer tax system, but he didn’t.

ProFutures Is Relocating

We are moving to a brand new building just down the street from our present location on March 18-19.  Our new address will be: 11719 Bee Cave Road, Suite 200, Austin, TX 78738.  All of our telephone numbers will be unchanged.