The US economy was stronger than expected in the 3Q with GDP expanding at an annual rate of 3.8%, following 3.3% in the 2Q.  Consumer spending remained brisk in the 3Q, up 3.9% over 2Q levels.  The unemployment rate fell to 5% in October.  But that’s where the good news ends.   Consumer confidence remains in the dumps, and the Index of Leading Economic Indicators plunged in September for a third consecutive decline. 

Despite the better than expected 3Q, the economy should continue to soften for the next several months.  The Bank Credit Analyst predicts 2-3 quarters of slow growth (less than 3% in GDP), but does not believe we are headed for a recession.  They do expect the economy to rebound in the second half of next year.  While we are hearing a great deal of concern over rising inflation, the BCA editors believe that inflation will actually be lower a year from now.

BCA believes that the slowdown in the economy will push equity prices lower for the next several months, and that earnings expectations for 2006 are way too high.  Thus, they continue to recommend below-average holdings of stocks.  They also believe that bonds will remain in a trading range for the next year or longer.

This month, we look at how to invest in such uncertain markets.  We look at the importance of avoiding large losses and the need for “Absolute Return” strategies  I have a new Special Report on absolute returns that is free of charge to clients.  If you don’t have it, call today.

Next, we take a look at some of the emerging trends in the real estate and housing markets.  There are some classic signs that suggest the bubble may be about to deflate.  Given those signs, the upcoming economic slowdown and rising interest rates, I recommend that you take profits on speculative real estate you currently own.

Finally, I offer President Bush some advice on page 8.  With his approval ratings in the dumps, he needs to get his act together.

Introduction

This month, we look at the latest economic reports, including the surprising report on 3Q GDP and the continued plunge in consumer confidence.  Next, I summarize the latest forecasts from The Bank Credit Analyst, along with their latest thinking on stocks and bonds.  From there, I ponder some new studies on whether retailers will have a "Blue Christmas" or happy holidays.  We end up with my advice on what to do in these very difficult markets.

The Economy - Good News & Bad News

Economic news of late has been mixed.  The best news is that the first estimate of 3Q Gross Domestic Product came in at an annual rate of +3.8%, well above the pre-report consensus of 3.5%.  2Q GDP was 3.3%.  3Q Consumer spending increased 3.9% over the 2Q, despite the hurricanes.  The unemployment rate fell to 5.0% in October.  So, the economy held up better than most analysts expected in the 3Q, despite the hurricanes. 

While it was encouraging to see that sales of new and existing homes were steady to slightly higher in September (latest data available), there are growing indications that the housing boom is coming to an end for now.  Personal income rose 1.7% in September, and consumer spending increased 0.5% in September as well.  The ISM manufacturing index rose to the highest level in a year in September, but edged slightly lower in October.  That's about where the good news ends.

At the top of the bad news list, the consumer confidence indicators worsened again in October, when most analysts had expected at least a modest bounce in confidence following the huge plunge in September.  However, the Conference Board's Consumer Confidence Index fell further in October, as did the University of Michigan's Consumer Sentiment Index.  In the Conference Board's latest consumer survey, only 23.8% of respondents described business conditions as "good."

The much-watched Index of Leading Economic Indicators (LEI) fell sharply in September, down 0.7%, thus marking the third consecutive monthly decline.  The Conference Board's CEO Confidence Index fell from 55 to only 50 in the 3Q, which is the lowest reading in four years.  Orders for durable goods also declined another 2.7% in September.  Auto sales fell 14% in October.

While the "advance" GDP estimate of 3.8% is encouraging, there is still little doubt that the economy will slow down in the 4Q and the 1Q of 2006.  The question is, how much?  The more optimistic estimates put 4Q GDP in the 3.0-3.2% range.  The more pessimistic estimates put 4Q GDP in the 2.0-2.5% range.  

The Bank Credit Analyst's Latest Thinking

Martin Barnes and his fellow editors at BCA have a similar view of the economy over the next 2-3 quarters.  They say:

". . . the pace of the U.S. economy is set to weaken for two or three quarters, led by a consumer retrenchment.  A mid-cycle slowdown is in the cards, rather than a recession, because the corporate sector is in excellent financial shape, and, as noted above, there is no need for severe monetary restraint. Nonetheless, the economy should be soft enough to cause a downgrading of current overly optimistic corporate earnings expectations, creating a headwind for the equity market."

As noted in the quotation above, the editors at BCA do not believe the US economy will experience a recession in the next year, barring any major negative surprises.  Instead, they expect 2-3 quarters when economic growth will be "below trend" (BCA-speak for below 3%).  Following that, the editors  expect the economy to rebound in the second half of next year.

Inflation is on the rise, and this is becoming a big concern among economists and investors.  The Consumer Price Index rose 1.2% in September, and has jumped to 4.7% above the level it was one year ago, largely due to the explosion in energy and related prices.  However, the "core rate" of inflation - CPI minus food and energy - is at 2% currently, and this is the index the Fed is said to watch most closely when setting monetary policy.

Many pundits and financial analysts (and the gloom-and-doom crowd, as always) are warning of much higher inflation to come.  Yet BCA has a different view, despite continued high energy prices.  BCA's view is that inflation will be LOWER, not higher, a year from now.  Here is their thinking.

Obviously, soaring energy prices have pushed up the CPI; however, we have not seen a similar spike in other consumer goods sectors.  And in fact, high energy prices have made many consumers cut back on other purchases, thus keeping the core inflation rate near 2%.

BCA offers several main reasons why inflation in the US is not about to soar higher, despite higher energy prices.  First, competitive pressures abroad will continue to keep prices for globally traded goods relatively low.  According to US import statistics, prices for imports coming from Asia and China are still falling overall.

Second, the investment technology revolution is still unfolding.  While prices for computers and software are not falling as they did over the past two decades, continued advances in technology help companies boost productivity, reduce costs and thereby absorb much of the increased cost of energy.  Corporate profit margins have hit a post-WWII high, despite the spike in oil prices.

Third, one of the largest factors affecting the inflation rate is labor costs.  BCA points out that wage increases have not kept pace with the inflation rate over the last two years.  Furthermore, in today's very competitive global market, labor has little bargaining power for higher wages.  Thus, the labor component of the inflation rate is not in a position to rise significantly.

Fourth, while BCA remains bullish on energy prices over the long-run, they believe that oil and gasoline prices will continue to fall over the next 6-12 months or so. 

Fifth, BCA expects the Fed to continue raising short-term rates two or three more times, which will continue to keep a lid on inflation.

And lastly, BCA believes that the global war on inflation over the last 20-25 years has largely succeeded in eliminating the "inflationary psychology" of companies around the world.  BCA contends that when companies are faced with higher costs, they now first look to boost efficiency internally, rather than automatically raise prices.

While the University of Michigan consumer survey has shown a big spike up in inflation expectations over the last two months, BCA believes - for the reasons cited above and others - that inflation will actually be lower a year from now.  This may explain why the rise in gold prices has stalled in the $460-$480 range recently.  It may also explain why bonds have not broken out of their two-year trading range to the downside.

BCA Conclusions & Latest Market Advice

In summary, BCA expects 2-3 quarters of "below trend" growth in the economy, with GDP in the 2-3% range, and no recession, barring some major negative surprises.  They expect the Fed to continue its inflation fighting policy with 2-3 more quarter-point hikes in the Fed Funds rate, and then go to a neutral policy early next year under new Fed chairman Ben Bernanke.  The BCA editors expect the US economy to strengthen again in the second half of 2006.

As for the investment markets, BCA is not optimistic about the equity markets.  This is not surprising given their outlook for an economic slowdown over the next 2-3 quarters, and the continued rise in short-term interest rates.  Most notable, however, BCA believes that earnings forecasts for 2006 are significantly overstated.  They say:

"Analysts are rashly assuming that nothing will harm corporate profitability, and that is bound to lead to disappointment.  The bottom-up consensus of analysts' projections implies that S&P 500 operating earnings will rise by 12.4% in 2006, only slightly down from this year's expected growth of 14.8%.  Our earnings model paints a very different picture, with earnings growth expected to slow to around zero [in 2006].  The trend in the leading economic indicator also supports the case for slower earnings growth." [Emphasis added, GH.]

This is a significant departure from the current thinking on Wall Street.  If BCA is correct that we face a major contraction in corporate earnings next year, the equity markets are almost certain to move lower.  BCA is NOT predicting a new bear market in equities, but they do believe that stock prices in general will move somewhat lower over the next several  months.  As a result, BCA continues to recommend below-average positions in equities.

While BCA remains long-term bullish on stocks, they believe there will definitely be a better (cheaper) opportunity to move back to a fully-invested position in equities over the next few months.  This suggests that, at the least, the Dow Jones will move back to the low end of the two-year trading range (9,700-10,900) or lower.  If so, the S&P 500 would do likewise (1,160-1,240) or lower.

As for bonds, the BCA editors believe that medium and long-term rates will remain in the trading range of the last two years.  While most analysts are predicting that yields on the 10-year Treasury Note will rise to at least 5% from the current level of 4.5% - due to inflationary expectations - BCA believes that the 10-year Note will remain in the recent trading range of 4%-4.6%.  In short, they believe that bonds will be a "boring asset class" in the next 3-6 months.

To subscribe to The Bank Credit Analyst, go to www.bcaresearch.com - I highly recommend it.

Could The Economy Surprise Us Once Again?

I have been a continuous subscriber to The Bank Credit Analyst for the last 28 years.  Over that time, I have found BCA to be the most accurate forecaster of major economic trends, major inflation trends and major market trends of any source I have found.  But BCA is not perfect, and forecasting short to medium-term trends is very difficult for all market analysts.

The current situation is indeed complicated, what with soaring energy prices and three national disasters (Katrina, Rita and Wilma).  Immediately after Katrina and Rita, many analysts predicted that a recession would follow.  Likewise, many analysts predicted that stocks would plunge and interest rates would soar.  The gold bugs were ecstatic.

Yet the fact is, the economy and the markets have held up much better than initially expected in the wake of $70 oil and three devastating hurricanes.  Could it be that the next 3-6 months will not be as bad as expected?

I must admit that the economy and the markets have held up much better than I expected after Hurricane Rita in late September.  The 3.8% increase in 3Q GDP was a big surprise, as discussed above.  The US economy is extremely resilient, despite our massive trade and budget deficits and the zero savings rate among Americans.  The US economy has consistently surprised on the upside for over two decades now. 

While there will no doubt be a painful time of reckoning for our deficits and pitiful savings rate sometime in the next few years (ie - a severe recession or worse), there is a chance that the next 3-6 months will not be as bad as we expect, especially if oil and gasoline prices continue to fall as BCA predicts for the next few months.

In my weekly E-Letter, I have predicted a disappointing holiday shopping season for retailers; however, several new studies suggest just the opposite.   The National Federation of Retailers projects that holiday retail sales will rise 5% this year, as compared with a 6.7% increase in 2004. 

Two independent economic research firms - Jupiter Research and Forrester Research - project that holiday sales on the Internet will jump by 18% to 25%, respectively, this year, despite the hurricanes and high gasoline, natural gas and heating oil prices.  Keep in mind that more and more people are getting comfortable shopping on the Internet every day, so these numbers may not be a good barometer of consumer spending habits for the holidays.

Are these forecasts too rosy?  I think so, especially with consumer confidence in the tank and a negative savings rate.  But the point is, the economy may not weaken as much as we expect over the next 3-6 months.  This assumes, of course, that there are no major negative surprises, terrorist attacks, etc.

How To Invest In These Uncertain Times

As I discuss in my latest Special Report on "ABSOLUTE RETURNS," I believe there are two critical issues when it comes to investing, especially in the trading range markets we find ourselves in today:

·    First is AVOIDING LARGE LOSSES by using active management strategies that can "hedge" or move to cash in downward market trends.

·    Second is seeking ABSOLUTE RETURNS by using strategies and programs that have the potential to do well in up or down markets.

If you would like a copy of my latest Special Report on Absolute Returns, be sure to call us today at 800-348-3601, and we will send you a free copy, or you can visit our website at www.profutures.com.  The Report explains in detail what Absolute Returns are and how to get them.

Expectations For Returns Going Down

If you study the stock markets at all, you are no doubt aware that return expectations have come down significantly over the last couple of years.  Even most bullish forecasters have come to the conclusion that equity prices, as measured by the S&P 500 Index, will not live up to the Index's historical average annual return of just under 11%.

More and more stock market analysts are now predicting that the S&P 500 will average only 5-7% annually at best over the next 10 years or longer.   The Bank Credit Analyst has been saying this for over a year now.

Yet what many investors do not realize is that while average upside returns will likely be lower over the next 10 years, the downside risks are still as large as ever.  I'm not predicting that the S&P 500 is going to plummet 44% as it did in 2000-2002 (although it can't be ruled out), but I fully expect we will see some declines of 25% or more over the next decade.

If you're only making 5-7% on average in the good times, you absolutely need to protect your downside in the bad times.

All of the active management strategies that I recommend have capital preservation at their core.  They have built-in systems to "hedge" during market downturns, or move partially or fully to cash (money market) if market conditions so dictate.

The goal of the programs and the Investment Advisors I recommend is to generally deliver market rates of returns in the good times, and lose half or less what the market does in the bad times.  While past performance is not necessarily indicative of future results, the programs I recommend have been quite successful in limiting losses during the bad times in the stock markets. 

For these reasons and others, more and more investors are looking for professionals to manage a portion of their portfolios.  More and more investors are embracing active management strategies, such as those I recommend, because: 1) they don't know how long the markets will remain in these broad trading ranges; and 2) they want the potential for limited losses during down periods in the markets.

In addition to seeking to limit losses, more and more investors are looking to diversify into different approaches and strategies in their portfolios.  This is not surprising given the difficult market conditions we face.  It has long been my belief that investors should diversify among investment strategies the same way they do in different asset classes .  These strategies can include active management, asset allocation, sector rotation, fundamental analysis (value investing), alternative investments, managed futures and real estate, among others.

The programs I recommend are for those investors who want proven professional Investment Advisors making the decisions on: 1) when to be in the market; 2) which sectors to be in at any given time; 3) which mutual funds to own; and 4) most importantly, when to be "hedged" or out of the market in the safety of cash (partially or fully). 

That's precisely why I have the bulk of my own personal investments allocated to active management strategies managed by professionals.  I encourage you to check out the active management programs available through AdvisorLink®, if for no other reason than added diversification.

We have several recommended Advisors that specialize in equities only, and others who specialize in bonds only.  Several of the Advisors have multiple strategies.  Minimum account requirements vary from as little as $15,000 up to $100,000.

A Manager Of Managers - "MOM"

As long-time clients are aware, ProFutures is what is known as a "Manager of Managers" (MOM).  We specialize in finding successful money managers and introducing clients to them.  Each year, we spend a lot of money attending conferences and seminars where professional money managers gather.  We subscribe to several services that track large numbers of professional money managers.  We are constantly searching for successful money managers.

Before we recommend any money manager, we conduct a "due diligence" visit to their offices.  We meet personally with the manager; we have him/her explain to us in detail just how his/her system works; and we meet the key people on the staff.

Most importantly, we look at randomly selected customer accounts to see if the performance record the manager is claiming actually is similar to the performance in actual customer accounts.  Only if everything meets with our approval do we then recommend the Advisor to our clients.

Before any client opens an account with one of our recommended Advisors, I open my own personal account.  I have my own money invested in every program we recommend.  In fact, the bulk of my net worth is invested in these programs.  This comes in handy in terms of tracking the Advisor's performance on a daily basis.

You are probably wondering how my company gets paid in this arrangement.  Most professional money managers are willing to share a portion of their management fees with my company in return for introducing clients and maintaining the client relationship.  Typically, they share one-third to one-half of their annual management fee with us.

In summary, I think most investors should consider active management strategies, especially in these uncertain markets.  I believe most investors should have some of their money with professional  managers who have the flexibility to hedge or move partially or fully to cash.  For more information on the managers I recommend, you can call us at 800-348-3601 and speak to one of our Representatives, or you can visit our website at www.profutures.com .

I am not a real estate expert by any means, although I have done very well in my few ventures into commercial and residential property.  In keeping with my mantra of "professional management," the lion's share of the money I have made in real estate has come from investing with professionals who knew what they were doing.

There are signs that the boom in home prices is leveling off, certainly in some parts of the country.  While sales of new and existing homes remain high according to the latest reports, the number of homes on the market is increasing rapidly.  Also the time required to sell a home is increasing in most areas.  And in some areas, prices have actually started to soften.  Much the same is taking place in the commercial real estate market in many areas.

I have seen numerous reports that sales of high-end luxury homes are taking much longer, and prices are actually falling in various areas.  This is certainly true here in Austin.  And keep in mind that as more and more Baby Boomers retire, many will be looking to sell their high-end homes and downsize.

As I’m sure you know, speculation in real estate has skyrocketed over the past couple of years.  Many investors who are not experienced in real estate have gotten in the game.  They buy homes or real estate, hoping to “flip” them quickly for a tidy profit.  We’ve seen this before, and it usually ends ugly.

All of these are classic signs of a market top.  It remains to be seen if the housing bubble will end with prices going sideways for a while, or if prices fall modestly over the next year or so, or if the bubble bursts.  That is a possibility, of course, but the timing is impossible to know, although I expect we will know sooner rather than later.

Keep in mind also BCA’s prediction that inflation will be lower a year from now.  If correct, that is another possible negative for real estate.

Here is my point: If you own real estate as an investment, now may be a very good time to sell and take some profits.  As we all know, real estate prices have skyrocketed in the last few years, along with home prices.   In some ways, the real estate market is just looking for a reason to go down.  The fallout from the hurricane, as discussed above, could well be the trigger.

Do not read me wrong.  I am NOT suggesting that you sell your primary residence.  I have never in 28 years of writing recommended that people sell their primary home and rent.  For people who sold their homes five and 10 years ago - thanks to fear-mongering by the doom-and-gloom crowd - it has been a disaster.  They missed the best real estate market in decades.

But many clients and readers of this newsletter own real estate and real estate funds that they bought simply as investments, to diversify their portfolios, in the hope that prices would rise.  And they have, spectacularly in most cases.  If you have owned real estate as an investment for long, it is likely that you have seen tremendous increases in value. 

With the economy set to slow down over the next six months or longer, and with the near certainty that the Fed will continue to raise interest rates, there is more than a fair chance that real estate values will come down, perhaps significantly in some areas.  Now may be the time to take profits.  Unlike stocks or bonds or commodities, it is not easy to hedge real estate.  There is no futures market in real estate.  About the only way to lock in real estate profits is to sell.

As always, I could be wrong.  But I would seriously recommend that you consider reducing your exposure to speculative real estate.  Also, consider your investment in REITS, which could be hurt.  It never hurts to take a profit.

The Implosion Of The Bush Presidency

For the first time in his presidency, a new poll shows that a majority of Americans would vote for any Democrat running against President Bush if the presidential election was held today. The CNN/USA Today/Gallup poll taken in late October found that a stunning 55% of respondents would vote for a Democrat for president, whereas only 39% would vote for Bush in such a hypothetical election were it held today.  This is the first time any such poll has tipped in the Democrats’ favor since Bush moved into the White House in 2001.

The same poll found that 57% don’t agree with President Bush’s views on issues that are important to them.  On specific issues, a majority of those questioned felt the Democrats could do a better job than Republicans at handling: health care (59% to 30%), Social Security (56% to 33%), gasoline prices (51% to 31%) and the economy (50% to 38%).  Democrats have traditionally led on the issues of Social Security and health care, but rarely on the economy or market forces such as gasoline prices.

As this is written (November 8), President Bush’s approval rating is at an all-time low of just 38.8%, while his disapproval rating is at an all-time high of 57.6%, based on an average of five separate polls.  The wheels are literally falling off of President Bush and his administration , as much as I hate to admit it.

I devoted the October 11th issue of my weekly E-Letter to a detailed evaluation of the Bush presidency from the beginning.  The article was entitled, “Will The Real George W. Bush Please Stand Up.”  In the piece, I chronicled all the instances where President Bush has disappointed conservatives, and they are many, sadly to say.  While Bush was proving that he could spend with the best of the Democrats, most conservatives held their tongues and stood by the president due to their confidence that he would nominate true conservatives to the Supreme Court.  He promised us repeatedly in both of his campaigns that he would nominate Supreme Court justices in the mold of Antonin Scalia and Clarence Thomas.  But we were to be disappointed here, too.

John Roberts was at best only a luke-warm nominee to conservatives - a moderate conservative, that is.  When Chief Justice Rehnquist passed away, conservatives were sure that Bush would elevate Scalia to Chief Justice.  He has certainly earned it.  Yet Bush passed over 69 year-old Scalia in favor of John Roberts who could easily serve 30 years or more - clearly a “legacy” pick for Bush.

Then came Harriet Miers - who??  Conserva-tives had a conniption, and rightly so!  Bush ultimately had to withdraw her nomination in what was a huge firestorm.  Meanwhile, Karl Rove and Scooter Libby were under investigation by a federal prosecutor, which ultimately indicted Libby.  Rovefuture is still in doubt.   Again, the wheels are falling off of the Bush administration.

Democrats Are Licking Their Chops

President Bush has given the Democrats new life, and many now believe they can retake the House and the Senate in 2006, or if not, then in 2008 when they believe that Hillary Clinton will be elected president.  What a scary thought!  There are those who believe President Bush will get his act together, and with three more years to serve, he will stage a strong comeback.  I hope so, but my advice to  President Bush is that old saying: “When you’re in a deep hole, stop digging!”