The Commerce Department estimated 2Q GDP growth at 3.4% (annual rate), well above expectations.  That followed growth of 3.8% in the 1Q.  The economy should remain firm for the next 6-12 months at least. 

The Conference Board, which publishes the much-watched Index of Leading Economic Indicators (LEI), recently announced it has made significant revisions in the way the LEI is calculated, largely due to major changes in the interest rate environment.  As a result of the revisions, the LEI actually increased by 1.2% over the last six months, rather than a decline of 2.2% as previously reported.  It was the decline in the LEI which led many analysts (including me) to predict that the economy would hit a temporary “soft-patch” this year.  Yet based on this new information and the latest strong economic reports, it appears we have avoided a slowdown.

Based on the strong economic data, it now appears very likely that the Fed will raise interest rates at least two more times (this month and again in September) to the level of 4% in the Fed Funds rate.  There is a good chance the Fed will stop at that level, or at least go “on-hold” since they do not want to create an “inverted yield curve” and risk a recession.

As this is written, stocks appear to be breaking out of the long trading range to the upside.  Hopefully, you have followed my advice in recent months and are now fully invested in equities.  If not, I would use any near-term weakness to add to positions.  All of the equity managers I recommend are long in stock mutual funds.

Oil prices remain above $60 a barrel.  At this point, the energy markets are in a speculative frenzy.  But keep in mind that oil is a commodity; what goes up always comes down; and do not be surprised to see a selloff of $15-20 a barrel at virtually any time.

Lastly, it is my opinion that the new energy bill passed by Congress is little more than another pork barrel boondoggle that, admittedly, will cost taxpayers at least $66 billion over the next 10 years.  President Bush should veto this bill, but he won’t.  See discussion on pages 7 and 8.

Introduction

If you listen to the media, you would think that the US economy is falling into a slump.  However, the latest data suggest otherwise.  In late July, the Commerce Department estimated 2Q Gross Domestic Product rose at an annual rate of 3.4%. This followed the government’s revision of 1Q growth from 3.1% to 3.8% for the 1Q, which was  well above expectations.   So the economy has not slowed down as had been predicted by many.

In fact, if we look closer at the latest GDP data, we find that total sales of domestic products (not counting exports) rose a whopping 5.8% in the 2Q.  That is more than double the domestic sales rate at this time a year ago. 

This strong demand in the first half of the year led to a significant drop in inventories at the nation’s retailers and manufacturers, especially in the 2Q.  Manufacturers are now ramping up production to rebuild inventories.

Personal consumption spending, which accounts for over two-thirds of GDP, rose at an annual rate of 3.6% in the 1Q - again, well above economists’ expectations.  In June, personal consumption spending rose by another 0.8%, also above expectations.  We are told that consumers are in a funk, largely because of the war in Iraq, but guess what – the Consumer Confidence Index jumped to a three-year high in June, although it dipped slightly in July.

The unemployment rate has declined steadily this year.  The latest data for June shows that the national unemployment rate fell to 5.0%, down from 5.1% in May and 5.2% in April.  While the overall number of new jobs created is still disappointing, the trend is improving and the overall unemployment rate has not fallen to 5% in almost four years.  Have you noticed how the media has backed away from criticizing President Bush on jobs growth?

The Institute for Supply Management’s (ISM) manufacturing index rose to 53.8% in June, marking the 25th consecutive monthly increase.  Any reading in the ISM Index above 50 represents a growing manufacturing economy.   US manufacturers have increased spending on new plants and equipment to the highest rate since 2001 according to the latest Census Bureau report released in July.

Durable goods orders jumped a surprising 1.4% in June, even though economists had predicted a decline of 1%.  Durable goods orders declined in the first two months of this year but have now risen strongly for the last three consecutive months.

The housing boom also continues with housing starts maintaining a record pace.  There was a significant drop in housing starts in March, which made many commentators suggest that the bubble was bursting, but housing starts increased 11% in April/May. 

I think we can all agree that the housing market is increasingly becoming a speculative bubble, but this bubble could well last another year or two.  Remember when we all thought the high-tech stocks were in a bubble in late 1998 when the Nasdaq Index hit 2000?  It went on to top 5,000 in the next two years.  Bubbles tend to go farther and last longer than conventional wisdom would suggest.  The housing boom may be yet another example.

The bottom line is that the US economy continues to grow strongly.  The so-called “soft patch” alluded to by Fed chairman Alan Greenspan and many others has simply not happened.  Economists are now revising upward their estimates for economic growth in the second half of the year. 

The US economy continues to surprise on the upside, just as it has for the last 25 years or longer.  Growth in the second half of the year should be at least 3½-4% and continue well into 2006.   

The Index Of Leading Economic Indicators

One of the main reasons for the forecasts for a slowdown in the economy has been the decline in the Index of Leading Economic Indicators (LEI) earlier this year.  The LEI fell for six consecutive months (Dec-May) by a total of 2.2%.  I must admit that the LEI is one of the main indicators I use to gauge economic trends, so it is not surprising that many analysts predicted at least a modest slowdown in the economy for the 2Q and the 3Q.

The latest LEI report for June, however, showed a significant upturn of 0.9%.   That is consistent with the other positive economic data I have presented above.  But that still does not explain the slump in the LEI earlier this year.

Well, with the release of the June LEI report on July 21, the Conference Board announced that it has made “major revisions” to the way the LEI is calculated.  Here is what they said in the press release:

“Based on the benchmarked figures announced today, the leading index increased sharply in June following no change in May. The revised leading index has increased at a 1.2 percent annual rate over the last six months...”

Oops!  So the index is revised from a drop of 2.2% in the six months ended May to an increase of 1.2% for the six months ended June.  So if we were wondering why the “soft-patch” didn’t happen, here is a big part of the reason.

The Conference Board admits that the LEI Index needed to be revised significantly due to the new interest rate environment we are in.  Specifically, “a new method of calculating the contribution of the yield spread... by better reflecting the way the yield spread anticipates cyclical economic turning points.”  Well now at least we know.  The LEI had not adjusted for the current low interest rate environment.  Hopefully, it will again be a better indicator in the future as it has been in the past.  We’ll have to see.

Fed To Continue Raising Rates

The fact that the economy is rising stronger than previously believed is certainly good news.  However, it also means that the Fed is almost certain to use this opportunity to raise short-term rates at least a couple more times.  Following the increase in June, the Fed language remained the same – that they will continue to raise short rates at a “measured pace.”

Given that most analysts expected a soft-patch in the economy during the middle of the year, there was a good deal of optimism that the Fed might end its rate hiking cycle at the FOMCmeeting on August 9.  But in light of the good economic news and continued low inflation, hope has all but vanished that the Fed will stop.

It is now widely expected that the Fed will raise the Fed Funds rate to 3.5% next week from 3.25% currently.  This will mark the Fed’s 10th consecutive 25 basis-point increase in the key short-term funds rate.  Most analysts also believe the Fed will continue these increases until the rate reaches 4%.  It remains to be seen what will happen after that.

The Interest Rate “Conundrum”

Perhaps the largest market miscalculation in recent years has been the sharp drop in long-term interest rates at a time when 1) the economy has recovered strongly, and 2) the Fed has been raising short-term rates.  Other than the deflationists and some in the gloom-and-doom crowd, very few analysts predicted that long-term rates would fall as they have in the last few years.

In early July, the yield on the 30-year Treasury bond had slipped to 4.32%; the 10-year T-Note was down to 4.07%; and the 1-month Treasury bill was at 2.96%.  The national average 30-year fixed mortgage rate (80% of value) is hovering just above 5.5%. 

These low rates defy conventional analysis.  In testimony before the congressional Joint Economic Committee earlier this year, Fed chairman Alan Greenspan described it as a “conundrum.”  He admitted that he is at a loss to explain how long-term rates have fallen so far in the midst of a strong economy and the Fed raising rates aggressively on the short end.  It was a rare moment for Mr. Greenspan.

So why have long rates dropped so much, contrary to their long history of rising when the economy rebounds?  Quite simply, because 1) there is a global glut of excess savings and huge oil profits that continue to buy US Treasuries and other fixed-income securities, and 2) inflation is not rising as it historically has when the economy rebounds.  These two factors are the main reasons why long rates have moved lower than just about anyone predicted.

The Global Glut Of Savings

Falling long-term rates are not simply a US phenomenon.  Long rates are falling in almost all of the major economies around the world.  The fact that long rates are falling significantly in most parts of the world is a sign that there is a large excess of savings around the world. 

The Asian economies have recovered along with the US economy, and the Asians continue to be a high savings society.  They receive US dollars for the imports we buy from them, and they in turn pour much of that money right back into the Treasury markets.

Every oil producing country in the world is experiencing a windfall of profits with oil soaring above $60 per barrel.  Oil is bought and sold in US dollars.  Not surprisingly, much of that windfall is buying Treasury securities, thus driving rates even lower.

Since we are running the largest budget deficits in history, the US government has been the beneficiary of this global glut of savings, in that interest rates have plunged and we are now paying much less to finance the national debt. 

The masses of foreign buyers of Treasury debt know this is not a good thing, that it can’t continue forever, and that the party will come to an ugly end at some point.  But for now, the lines are long (so to speak), and the world’s savers continue to lend to the world’s biggest borrower, Uncle Sam.     

Inflation, Deflation & The Fed

How could anyone say that inflation is not a problem with oil prices soaring above $60 per barrel?  Yet even with the explosion of energy prices, the Consumer Price Index has only risen to the 2.5% level over the last year according to the Labor Department, as of the end of June.  If we look at the “core rate” of inflation (excluding food and energy), we find that consumer prices are increasing at an annual rate of only 2.0%. 

It is the core rate of inflation that the Fed focuses on, not the CPI.  At a rate of 2% or less, the Fed is actually quite comfortable that inflation is under control – even though they don’t say so.  If this is true, then the logical question is, why does the Fed continue to ratchet up short-term rates?  The reason is that the Fed is “reloading” out of fear of deflation.   

The Fed realizes that the next recession in the US could present a very serious financial dilemma.  With America running huge budget and trade deficits, with the decline in personal savings now down to zero, and with the decline in the US dollar over the last couple of years, the next recession is likely to be a severe one.

If the US goes into a recession, most of the rest of the world will follow.  The long lines of foreigners who are soaking up record amounts of US debt today could largely disappear – and very quickly - if the US goes into a recession.   Or, should I say when the US goes into a recession.

The Fed wants to raise short rates as much as it can so as to have more ammunition to fight the next recession whenever it unfolds.  This explains why they continue to raise rates even though the core inflation rate has stabilized at around 2%.      

There is a very real possibility that we could be facing a deflationary environment whenever the next recession unfolds.  No doubt, the policymakers at the Fed know this, and they also know that with the Fed Funds rate at 3¼%, they don’t have a lot of room to slash short rates to fight a recession and a deflationary trend.

How High Is High Enough?

As noted above, it now appears all but certain that the Fed Funds rate will climb to at least 4%.  The Fed has a difficult balancing act.  On the one hand, they want to raise short-term rates as much as possible in order to be in a better position to combat deflationary forces whenever we hit the next recession.  On the other hand, they do not want to cause a recession by raising rates too much.

While many analysts had hoped that the Fed might stop increasing short-term rates once they reached 3.5%, most are now considering whether the Fed will stop at 4% in November.  Obviously, it is impossible to know.  The FOMC members themselves probably doneven know.

There are two more FOMC meetings this year following the September meeting: November 1 and December 13.  My guess is that the Fed will elect at the November meeting - when it is likely to raise the Fed Funds rate to 4% - to go on hold.  I could be wrong, of course, but my guess is that the Fed governors will decide that 12 consecutive rate hikes have been enough, for the time being at least. 

One reason to stop, or at least go on hold, at the November FOMC meeting is the risk of an “inverted yield curve,” where short-term rates rise above long-term rates.  As this is written, the yield on the 10-year Treasury Note is 4.3%, and it has been as low as 4% earlier this summer.  If the Fed raises short rates above 4%, the yield curve will begin to invert, and this is a classic signal that a recession will follow fairly soon thereafter.  So my guess is that the Fed will at least go on hold after September.  

Stocks Breaking Out To The Upside?

For the last several months, I have made the case that there would be a buying opportunity in stocks sometime this summer, and that equity prices in general will break out of the current trading range to the upside.  One reason for that optimism has been the fact that  stocks have held up quite well over the last year or so given the Fed’s rate hikes and oil soaring to over $60 a barrel.  I have also suggested that with the continued strength in the economy, stocks have some catching up to do.

As this is written, several of the major equity indices have broken out to new 4-year highs.  The S&P500 Index and the Nasdaq 100 Index have both climbed slightly above the trading range of the last 18 months.  The Dow has yet to follow suit, so I would be reluctant to conclude that we have seen a broad-based breakout to the upside.  But I do believe equity prices will trend higher later this year.

There is a chance that equity prices could have another mild setback if the Fed raises interest rates again at the FOMC meeting on August 9.  Yet as discussed above, expectations for another rate this month are widespread, so it may be that another quarter-point hike will be a non-event, and stocks may continue to push higher in any event.  Hopefully, you have taken my advice and are in a fully-invested position already.

It may interest you to know that most of the equity managers I recommend have already begun to rebuild long positions in the various mutual funds in which they invest.  As this is written, Niemann and Potomac are virtually fully invested; Scott Daly is 75% invested, and Third Day is apprx. 50% invested in mutual funds.

Given my market outlook noted above, I believe that NOW may be an excellent time to open accounts with any of the Investment Advisors I recommend that invest in equity funds.

What’s Ahead For Oil Prices?

As this is written, crude oil prices remain above $60 per barrel.  Who would have thought that we would be wishing for $50 oil!?  The oil market is clearly in a speculative frenzy at the moment, and no one knows for sure where prices should really be.  I think we can agree, however, that the market is overbought at levels above $60 per barrel.

There is an old saying in the commodities markets: “The solution to high prices is, high prices.”  At first glance, this saying seems to make no sense.  However, the higher prices go, the more demand is reduced and supply is increased.  Also, the longer that prices remain high, the greater supply will increase.

In the current case, there are some compelling arguments for high oil prices: 1) the supply of crude oil cannot be increased significantly overnight; 2) China’s demand for oil will likely increase even if prices remain high; and 3) even if supplies increase, there is not enough refining capacity around the world.  These are unusually bullish factors.

Nonetheless, oil is still a commodity, and what goes up eventually comes down.  The commodities markets have a long history of topping out just when things look the most bullish (and everyone has bought in).  Likewise, commodities tend to bottom out just when things look the most bearish.

Along this same line, it is common for there to be sharp downward “corrections” even in powerful bull markets.  In the case of oil, don’t be surprised to see a $15-$20 selloff at any time, especially given the magnitude of the latest run-up above $60.

I do not pretend to know where oil prices will top out, but they will top out at some point, and almost certainly a nasty selloff will follow.  I mention this only in order to tie back into my advice on the stock markets.    If oil prices top out this summer, and a significant selloff occurs, this should be very bullish for stocks.

Conclusions

The US economy remains on sound footing,  and GDPgrowth should be in the 3½ to 4% range, or higher, for the second half of the year.  There is a very good chance that at least the first half (and maybe all) of 2006 will also see solid economic growth.  It now appears we have avoided the so-called “soft-patch” that so many had predicted for the middle of this year.

As for the interest rate “conundrum,” there is no conundrum.  There is a glut of global savings that is soaking up US Treasury debt and inflation is low, thus driving long-term rates lower and lower both in the US and abroad.  The greater threat in our future is deflation, not inflation.

The Fed continues to hike short-term rates, not because it fears inflation, but because it fears that deflation could take hold in the next recession.  They are in a balancing act – on the one hand, they don’t want to choke off economic growth; on the other hand, they want to raise short-term rates (reloading) so as to have more room to cut rates when the next recession unfolds.

If the Fed stops raising rates later this year, or if there is a meaningful drop in oil prices – or both – this should be very positive for stocks.    I continue to believe that stocks will move higher over the next year or longer.  If you are not fully invested in equities already, Icontinue to recommend adding to positions on weakness just ahead.

As always, I recommend that you use professional money managers who use “active management” strategies for a significant part of your equity portfolio.  If you agree that the next recession will be a severe one, including a deflationary threat, then you want to have plenty of exposure to active management strategies that will exit the market if conditions warrant, and/or that can “hedge” long equity positions in the event of a severe market downturn.  For more information, call us at 800-348-3601 or visit our website at www.profutures.com.

By the time you read this newsletter, President Bush will likely have already signed the “Energy Policy Act of 2005.”  Unfortunately, as I will point out below, the new energy bill is just one more pork-barrel boondoggle that will cost taxpayers tens of billions of dollars and will NOT do much to solve our looming energy crisis.

For the last four years, President Bush has been trying to get a comprehensive new energy bill which, we were told, would boost domestic exploration, production and supply, help cut reliance on foreign energy, foster conservation, and increase the reliable delivery of electrical power.   All of this, we were told, would contribute to lower energy prices, or at least a slowing in the increase in energy prices over the next decade or longer.

Yet the new energy bill will accomplish little of that.  Instead, the new bill awards tens of billions to the big oil and energy industries, which are already enjoying record profits.  The legislation does almost nothing to slow the growth of dependence on foreign oil; it does little to encourage alternative energy sources; it does not do nearly enough to encourage a revival in nuclear power; and it does nothing to strong-arm the auto industry into producing more fuel-efficient vehicles.

The Wall Street Journal described the new energy bill as follows on Friday, July 29: “We can also say this for the bill: It doesn't pick energy winners or losers. Everyone who produces so much as a kilowatt hour is a winner in this subsidy-fest of tax credits and new federal mandates.”

The Energy Policy Act of 2005 will provide at least $12.3 billion of increased direct federal spending over 10 years, largely to the energy industry.  Never mind that the $12.3 billion alone is almost double the $6.7 billion the Bush administration asked for.  The bill also authorizes dozens of new taxpayer-funded subsidies, incentives and programs.   If all of these programs are funded and the tax breaks utilized, Congress itself estimates the cost at $66 billion over the next decade!  The private watchdog group, Taxpayers For Common Sense, estimates that if all these programs are funded and the tax breaks utilized, the cost will be over $80 billion!

“Big Oil” Is The Big Winner

As the Wall Street Journal quote above makes clear, the oil and energy industries are the big winners in the new energy bill.  Of the $14.5 billion the government will dole out in tax breaks, apprx. $9 billion of that will go directly to oil and gas companies and others in the energy sector, most of which are already enjoying record profits. 

In another major bone to big oil, the new bill suspends royalty payments the big oil and gas companies must pay the government to pump oil on government-owned lands.  One report I read over the weekend estimated that the suspension of these royalty payments will mean a $5 billion windfall for the major oil and gas companies that operate all of the offshore drilling rigs. 

Ironically, in an April 2005 speech to the US Hispanic Chamber of Commerce, President Bush stated, "With oil at more than $50 a barrel, energy companies do not need taxpayer-funded incentives to explore for oil and gas."  With oil now at approximately $60 per barrel, the argument is even stronger.

Ethanol - “Farm Bill II”

To the disappointment of many, the new energy bill does not reduce government subsidies for the production of ethanol.  In fact, just the opposite - the bill calls for annual production of ethanol to be doubled by the year 2012 and provides even greater incentives for doing so.  Not surprisingly, Midwestern state senators and representatives - Republicans and Democrats alike - voted in lockstep to get the extra pork for the corn farmers in their home states.  Of course, this massive increase in the production of ethanol will also benefit agribusiness giants like Archer Daniels Midland and Cargill who produce most of the ethanol in the US.

There have long been those who claimed that the production of ethanol is actually a net-negative energy equation.  In other words, it takes more energy to produce ethanol than we actually get from the final product, or so they claim.  According to a new study from Cornell University, the energy derived from a gallon of ethanol is less than the energy used to make it.  Yet the new energy bill will double annual production of ethanol by 2012.  Go figure!

Pros & Cons of the Bill

I should point out that I do agree with having a comprehensive energy policy, and that some of the provisions are very positive.  Tax credits (rather than tax deductions) for hybrid cars are a benefit, as is the extension of daylight savings time.  Another provision allows for more nuclear power plants to be built in the US.  Currently nuclear power accounts for only about 20% of electricity produced in the US, while it accounts for over 78% of all power in France.

US nuclear power development has been paralyzed by fears of another Three Mile Island or Chernobyl incident.  However, France has enjoyed a long history of nuclear power without serious incident.  If the French can do it successfully, then there is no question that we can do it just as well, and probably better.

As I see it, one of the biggest problems with the bill is that much of it is directed toward making fossil fuels more efficient rather than development of new technologies and renewable sources of energy.  Sure, the bill does have provisions for solar, wind and hydrogen fuel cell technology, but the amount of money allocated to the development of these technologies pales in comparison to what is given to existing sources. 

Another shortcoming of the bill, in my opinion, is that it did not include drilling in the Arctic National Wildlife Refuge (ANWR), as President Bush had proposed.  Bowing to Democrats who promised to filibuster the bill if it included drilling in the ANWR, the final bill left that vast energy resource untapped.

Perhaps the energy bill's most far-reaching provision is the repeal of the Public Utility Holding Company Act of 1935, which has blocked the owners of utilities from owning other companies and has prevented mergers in the electricity industry.  Utility officials and other proponents of repeal say it will attract capital, helping utilities build additional infrastructure that will prevent blackouts, but consumer advocates warn that the repeal will trigger a flurry of mergers and acquisitions within the utility industry, leading to increased utility rates and more opportunity for Enron-type fraud.  Both sides agree the repeal of the Public Utility Holding Company Act will greatly transform the industry in coming years, eventually thrusting as much as $1 trillion in utility assets into the global marketplace. 

Some complain that the energy bill does little to ease the pain of high and rising gasoline prices at the pump.  However, anything other than sending everyone a government check to help pay for gas would be impractical, if not impossible.  The price of gas and oil today is a function of refinery capacity and worldwide demand (ie - market forces).  Congress can't pass a bill to ease Asian demand for oil, nor can they wave a magic wand and make more refineries suddenly appear.

The new energy bill is just another example of pork barrel spending by politicians on both sides of the aisle.  President Bush should veto it!