The economy rebounded strongly in January, following the weaker than expected 4Q of 2005 when GDP expanded only 1.6% (annual rate).  Most of the economic and consumer reports for January were quite strong.  However, much of that good news was likely due to the fact that we had the warmest January on record.  In any event, economists are revising their forecast upward based on the January data.  February, on the other hand, was weaker than expected.  Consumer confidence plunged and retail sales surprised on the downside. 

Economists are now wondering whether January was the trend-setting month for the year, or was February the better indicator.  The Bank Credit Analyst predicts that the economy is going to go through a soft period for the next 2-3 quarters.  No recession, mind you, but a period where GDP growth slows to a pace of 3% or below, as compared to 3.5% in 2005 and 4.2% in 2004.  They believe stocks will manage some modest gains this year, but they also expect market volatility to remain very high, and therefore frustrating to most investors.  In the pages that follow, I’ll give you BCA’s latest forecasts.

Investors, by the way, are flocking back into the stock markets in near-record numbers.  Mutual fund sales have been enormous so far this year.  No one is exactly sure what has sparked this rush back into stocks, other than the fact that the major market indices have moved to new recent highs since the first of the year.  It is also unclear why most of the new money pouring into the market is going into “international” funds.  We will discuss this in the pages that follow. 

No doubt, there is a lot of uncertainty out there, especially if the US economy slows down for the next few quarters.  This is why I think you should consider our Absolute Return Portfolios, which consist of carefully selected mutual funds that have delivered good returns in both up AND down markets.  While past results are not necessarily indicative of future results, Ithink you will want to learn more about our Absolute Return Portfolios and the mutual funds we’ve selected.

Introduction

There is a consensus that January was a very strong month in the economy, following a weaker than expected 4Q.  Perhaps the biggest reason for the strong showing in January was the weather.  January 2006 was the warmest on record according to NOAA.  As a result of the warm weather, malls and shopping outlets were brimming with customers, and construction boomed in most parts of the country.

Based on the stronger than expected economic reports for January, most economists and market analysts are raising their estimates for 1Q GDP.  Some now believe the economy will grow by 5% or more in the 1Q.  Should this prove to be true, we could see more interest rate increases from the Fed than are currently expected.

Yet with January being so much stronger than expected, are we in for a disappointment when the February numbers come in?  I think so, and the few reports we have for February seem to bear this out.  Plus, the weather was much colder in February, with a blizzard in the Northeast. 

So while many economists are raising their economic forecasts based on January reports, we could see them revising those estimates back down again by the end of this month when we will have seen most all of the reports for February.  In short, economic growth for the 1Q, while it will be positive, may not be as good as presently expected.

In this E-Letter, we’ll look at the recent economic reports, inflation reports and the data on consumer confidence and spending to try to make sense of upcoming trends.  I will also give you The Bank Credit Analyst’s latest thinking on the economy, interest rates and stocks and bonds.

As you will read below, BCA expects another very volatile year in the stock markets.  If they are correct, you may want to consider investing in mutual funds that have a history of delivering positive “absolute returns” in up OR down markets.  There are some mutual funds that have done that.  I’ll tell you more about them as we go along.

Economy Rebounds Strongly In January

On January 27, the Commerce Department issued its preliminary estimate of 4Q GDP, showing that the economy grew at an annual rate of only 1.1% in the last three months of 2005.  That report was a shocker since the pre-report consensus was for a rise of nearly 3%.  Last week, the government revised 4Q GDP from 1.1% to 1.6%, still well below where expectations had been.

Despite the much slower than expected 4Q, there was some good news in January.  Perhaps due to the mildest January on record, consumers were in a good mood.  Consumer confidence jumped 2.3% in January.  Personal income was up 0.7% in January, and up 4.0% for the 12 months ended January. Consumer spending rose 0.9% in January, the best in six months. 

Retail sales were up 2.3% in January, and up 8.8% for the 12 months ended January.  The Index of Leading Economic Indicators rose a solid 1.1% in January.

Most surprising of all, housing starts jumped a whopping 14.5% in January.  No doubt this was due to the unseasonably warm weather across much of the country.  On the flip side, sales of new and existing homes decreased in January.  Sales of existing homes have now declined for five consecutive months.  Durable goods orders were down sharply in January, but this was largely due to large aircraft orders that reportedly were delayed until February.

The unemployment rate fell to 4.7% in January, down from 4.9% in December.  The unemployment rate has not been at 4.7% since July of 2001, prior to the 9/11 terror attacks.  Average hourly wages rose 3.3% for the 12 months ended January, the largest change in over three years.

Economists cited two main factors for the large spending increase in January: warm weather and gift cards. This January was the warmest on record, according to the NOAA National Climatic Data Center in Asheville, North Carolina.  In the fair weather, consumers returned to stores to redeem billions of dollars worth of gift cards. While the cards were purchased in the weeks and days leading up to the holidays, it is not until they are redeemed that they are recorded as actual sales.

On the inflation front, news was not so good.  The Consumer Price Index rose 0.7% in January, higher than expectations; however, the “core rate” – minus food and energy – remained at 0.2%.  It is supposedly the core rate that the Fed focuses on, but I can't imagine chairman Bernanke is happy that the CPI was up that much in January (more on this later).  In addition, wholesale prices rose 0.3% in January following a 0.6% rise in December.

While the economy stalled somewhat in the 4Q, with GDP rising only 1.6% (annual rate), it certainly appears that growth rebounded strongly in January.  With the positive news noted above, many economists are revising upward their forecasts for 1Q growth.  Several analysts have raised their estimates of 1Q growth to 5% or above.   

February Not Looking Good So Far

While economists and investors alike were reassured by the strong numbers in January, it looks like February will have been a disappointment.  We don’t have a lot of economic data for February yet, but we know that consumer confidence fell significantly last month.  The Conference Board’s Consumer Confidence Index fell from a revised 106.8 in January to 101.7 in February.  The University of Michigan’s Consumer Sentiment Index for February fell to 86.7, down from 91.2 in January.  It is still not clear exactly what caused the drop in consumer confidence last month.  Maybe it was weather, maybe is was political developments (UAE ports deal, etc.), or maybe it was a combination of both.

The ABC News/Washington Post Consumer Comfort Index in mid-February showed that only 17% of respondents believe the economy is improving.  Consumer confidence is an important indicator since it affects consumer spending, which accounts for almost 70% of Gross Domestic Product.

And so it was with retail sales.  In February, 60% of chain stores fell short of sales expectations following the strong surge in January.  Specialty apparel was especially hard hit in February with sales falling 1% versus a year earlier, when they had been expected to be significantly higher than in 2005.  The unemployment rate for February, to be released later this week, is expected to rise from 4.7% in January to 4.8% for February.

On February 12, a major snowstorm hit the Northeast and record breaking cold swept through most of the Midwest.  This undoubtedly affected consumer spending, but it remains to be seen if the drop in consumer confidence and spending last month reflects a trend, or is merely just a weather-related correction.

Most of the economic reports for February have yet to be released, so it remains to be seen if the economy cooled significantly last month.  But the early reports don’t look too good.  As I will discuss below, I believe there is a good chance that the economy will come in below expectations for all of the 1Q.  If the economy slows in February and March, the 1Q could see growth of only 2-3%.  I could be wrong, of course, and as noted above, most analysts are predicting growth of 4-5% for the 1Q.  We’ll see.

More Fed Rate Hikes Expected

The combination of strong economic numbers and higher than expected inflation in January suggest that the Fed will raise interest rates at least two more times.  Most analysts now believe the Fed will raise short-term rates by another 25 basis points on March 28 and again on May 10.   That would put the Fed Funds rate at 5%.

The big question now is whether the Fed will raise rates a 17th consecutive time to 5.25% on June 29 when the FOMC gathers for the fourth meeting of this year.  Based on the strong economic reports for January, more and more analysts are expecting a 17th rate hike in late June.  On Friday, for example, Lehman Brothers raised its Fed Funds target from 5% to 5.5%.

However, if the economy slowed modestly in February, as the early reports suggest, and if growth is somewhat subdued in March, as I expect, then there is a very good chance that the rate hiking cycle ends either with the March 28 increase or the May 10 increase.

FYI, the yield curve was as follows as of Friday:  3-month T-bill 4.60%; 2-year T-note 4.75%; and 10-year T-note at 4.69%.  To me, those numbers read “FLAT” but we will no doubt continue to hear warnings about the inverted yield curve.  Certainly, the Fed will be watching the yield curve closely as it makes its policy decisions in the weeks and months just ahead.

BCA’s Latest Thinking

In a nutshell, the editors at BCA believe that the economy is going to slow down this year after surprising on the upside for the last several years.  They believe that three primary factors – falling home prices, high energy prices, and the need to increase savings – will result in a modest reduction in consumer spending, which will result in a modest slowdown in economic growth over the next 2-3 quarters.

While the editors believe that the US economy is still in the midst of a “long-wave upturn” which could last another decade or so, they believe that the three factors noted above (plus others such as rising short-term interest rates) will cause the US economy to take a breather this year.  While they don’t put an exact number on it, they do say they expect growth to moderate to a level below 3% in the months ahead.

BCA does not believe we are headed for a recession this year or next year.  They merely believe that we will experience a period of slower than expected economic growth over the next 2-3 quarters.  In this scenario, the editors believe that inflation will slow down, and the Fed will not have to raise the Fed Funds rate above 5% later this year.

BCA expects the bull market in equities to continue this year, but they do not believe that returns will be exciting.  They use the word “grind” to describe the likely pattern in the stock markets, with lots of ups AND downs along the way to moderately higher prices overall.  BCA believes that equities will outperform bonds in 2006, and as a result, they recommend slightly higher than average holdings of stocks and lower than average holdings of bonds.  They say:

“… as long as we are correct that the Fed will soon put a halt to rate increases, then the odds are good that equity prices will grind their way higher over the course of the year.  It probably will not be a great year for returns, but stocks should beat both bonds and cash, warranting a modestly overweight position.”

BCA believes the US dollar will resume its long-term downtrend in the months ahead.  BCA says:

“The dollar outlook will be driven by expectations about the relative performance of the U.S. economy and by the relative stance of monetary policy.  On both grounds, it is reasonable to expect the dollar to decline.  There is increasing optimism about the growth outlook for Japan and the Euro zone, and expectations about the U.S. are likely to be revised down in the months ahead.”  I would suggest that the US dollar peaked last November, and the strength we have seen since late January has presented another short-selling opportunity.  

All of a sudden, investors are pouring near-record amounts of money into the stock markets.  As I will discuss below, individual investors are moving into the stock markets at a stronger pace than seen in years.  Money flowing into stock mutual funds rose to a near record amount last month.  Likewise, the number of stock trades at discount brokers rose substantially in January.

So, what's up?  Did someone ring a bell?  Why are investors suddenly pouring money into the equity markets?  Is it because the major stock indices have moved to the highest levels in nearly five years?  Is there somehow a renewed level of confidence in the economy, despite the disappointing 4Q GDP report?  Do investors believe the new Fed chairman will stop raising rates? 

An article in the Wall Street Journal in late February noted that, "Individual investors are moving into the market at a stronger clip than seen in years."  And in fact, there was a strong surge of new investor money going into stocks and mutual funds in January.  We have seen a similar trend at my company.  Calls from prospective investors are up, and even our existing clients are adding to their accounts and opening new ones.

At Fidelity Investments, the nation's largest mutual fund family, net flows of money going into stock mutual funds soared to $5.6 billion in January, up from only $400 million a year ago.  Fidelity said the large inflow represented new money coming in and the redeployment of money that was sitting in cash in brokerage accounts and money market funds.

Charles Schwab Corporation, for example, saw $4.5 billion flow into its stock mutual funds last month, the highest amount since February 2000, when net investments hit $4.7 billion.  February 2000 was, by the way, the top of the long bull market.

At Citi-Group, the Smith Barney Consulting Group division, which provides fee-based managed accounts, says investment flows into stocks so far this year are "substantially" higher than they were in 2005 and 2004. St. Louis-based brokerage firm Edward Jones saw new account openings in January rise 11% from a year ago, and says February growth is also strong.

The number of trades by individual investors at discount brokerage firms has risen substantially in recent months and jumped an estimated 30% to 40% in January from December. The discount firms, which offer lower-priced trades, also report that money flowing into stock mutual funds last month was at a near record level.

Equity fund inflows in January alone were a whopping $29 billion, according to AMG Data Services (AMG), compared to $38 billion for the entire 4Q.  I could go on with such numbers, but it is clear that investors are flocking into the equity markets this year.

Interestingly, new assets going into money market funds were up only $4.1 billion in January, compared with average January inflows of over $33 billion over the last 10 years, according to iMoneyNet.com.  This suggests that much of the money moving into stocks today is coming from the sidelines.

So Where Is The New Money Going?

A surprisingly large chunk of the recent inflows went into international mutual funds.  The international equity fund sector normally only amounts to around 15% of total assets of all stock mutual funds.  However, according to AMG, international funds captured about 80% of the huge inflows in January.  80% - wow!  According to AMG, four of the five mutual funds that saw the largest inflows last month were international funds, including Fidelity Diversified International, American Funds' Capital World Growth and Income Fund (Class A shares), Dodge & Cox International Stock, and the JP Morgan International Equity Fund (Select shares).  [Note: I am not endorsing these funds, just giving you the stats.]

Is the latest stampede into international funds and foreign stocks another example of investors chasing the latest "hot" returns?  The Morgan Stanley Capital International EAFE Index, a broad measure of stocks in Europe, Australia and the more-developed parts of Asia, gained 26% in 2005 in local-currency terms (or 11% when converted into U.S. dollars), outpacing the S&P 500 Index's 4.9% rise last year. 

Investing in international funds has long been a good way to diversify one's portfolio.  Yet in looking at the latest rush into such funds, it seems clear that some investors are loading the boat with foreign funds.  I would bet that many do not fully understand the volatility they may experience or the sudden movements that can and do occur in currency exchange rates, which affect international funds' returns.

In addition to international funds, a lot of new money is going into domestic equity funds.  In particular, investors are flocking to so-called "asset allocation funds" which diversify one's investment by holding multiple types of investments and asset classes within one fund.  AIM Investments, one of the huge mutual fund families, says that sales of its asset allocation funds are up 50% this year.

Why The Rush Into Equities Now?

There are numerous reasons why investors are flocking back into the equity markets.  Clearly, the fact that the equity markets have been rising since last fall has piqued the interest of more and more investors.  Many investors have been waiting to see if the Dow could get over 11,000 and stay there, which it has.  They may be viewing the latest strength as a buying signal.

Next, where else can investors go?  Rising interest rates are having a negative effect on both the bond markets and real estate, where a huge amount of money has been invested.  With the Fed expected to raise interest rates at least two more times, investors may be deciding that it's time to leave the bond market.  Ditto for real estate.

Next, aging Baby Boomers may finally be realizing that they have to save more for retirement.  Having been on the sidelines for several years following the bear market of 2000-2002, and seeing the market move to new highs recently, maybe now they've decided to jump back in. Many of the Boomers who have been on the sidelines since the bear market might be seeing that they have to be in the market to ever hope to reach their retirement goals.

Or, Boomers may now be realizing that they've left a LOT of money on the table since bailing out in late 2002 and early 2003 when the S&P 500 bottomed out around 800.  Today, the S&P 500 is near 1300.  That's a cumulative return of over 60%.  Greed is finally overtaking fear, apparently.

If they had taken my advice back in early 2003 to get back in the market before the war in Iraq started, and when the S&P 500 was near its lows, they would have enjoyed this nice ride.  I suspect that the renewed interest in stocks and mutual funds is the result of all the reasons outlined above, not to mention New Year's resolutions to save and invest more.

The Surge Into International Funds

As noted above, AMG reports that apprx. 80% of the new money flowing into stocks in January went into international mutual funds.  I must say that this number seems high to me, and I would not be surprised to see it revised lower once all the data are in.  Yet even if it was 50%, that's still huge.

Also as noted above, the Morgan Stanley Capital International EAFE Index rose 26% last year versus the Dow, which was down fractionally (-0.61%) in 2005.  However, when that 26% is converted to US dollars, the net return is only 11%.  Still, that's pretty good compared to the Dow and the S&P 500 last year.  In 2004, international stocks were second only to US small cap stocks.  No doubt, this superior performance in the last couple of years is drawing investors to the international funds. 

I wonder how many investors saw the 26% return last year but did not see the 11% net return after currency conversion?

Currency volatility is another real risk investors face when buying foreign stocks or international funds.  While foreign stocks may go up (or down), the currency they are denominated in can fluctuate, often significantly.  So, investors rushing into international funds now face not only the price risk of the shares going down (some analysts feel the international markets are overpriced today), but also the currency risk that goes along with these foreign companies.

Another factor that may be affecting investors' desire for international stocks could be the realization that the Fed may continue to hike short-term rates, and the growing potential for an inverted yield curve.  Maybe investors are buying into the gloom-and-doom crowd's hype that we're headed into a severe recession in the second half of this year. 

Again the question is, are investors just chasing the latest "hot" performance?  Time will tell, of course, but studies have shown that investors are frequently disappointed with their returns when they try to be in the latest hot sector - in this case, international funds.  For many years, I have written about the Dalbar studies which show that investors who chase the latest hot markets often find that they go cold just as quickly. 

It remains to be seen if this is the typical scenario where the smart money gets into an asset class that is undervalued; the value then goes up and gains the attention of the investment public; investors rush in, thus driving prices to over-valued levels; at which time the smart money moves out; and a decline follows.  Time will tell.  My main concern, however, is that many of these new investors may have put all or most of their portfolio in international funds recently.

We haven't seen any statistics regarding the investment activities of institutional investors or large hedge funds in the area of international stocks so far this year.  It will be interesting to see what these sophisticated investors do after this mass influx of money into international funds.

Finally, do not read the above discussion and conclude that I do not like international funds.  In fact, I am a huge fan of international funds, if selected carefully.  I absolutely believe that international stocks or funds deserve a place in a well-diversified portfolio.

The Need For “Absolute Returns”

For over a year, I have been emphasizing “absolute returns,” investment programs and funds with the potential to make money in up OR down markets.  If BCA is correct, we’re in for another very volatile stock market again this year.   The stock markets may well go modestly higher this year, but as we’ve already seen, the ride will likely be a wild one!

For this reason, I would recommend that you consider our new Absolute Return Portfolios.  After significant research and analysis, we have put together groups of mutual funds that have a history of performing well in up or down markets. (Past results are not necessarily indicative of future results.)

In addition to my company’s analysis of active money managers, we also have access to mutual fund databases and analysis programs.  This sophisticated software allows us to evaluate the performance of all mutual funds, and to select, among the thousands of alternatives, the ones that our analysis shows to have the best potential for ongoing absolute returns with limited risk. 

Instead of looking for the latest “hot” funds, we focus on funds that have a history of producing absolute returns in both rising markets and falling markets.  In most cases, these are not the top performers in any given time period.

Our clients know the fallacies in chasing the latest “hot” funds.   So what we looked for among the thousands and thousands of equity mutual funds were those funds that I would characterize as “Steady Eddie” funds – those that have delivered good returns (although not necessarily the highest) through various and different market environments – with limited drawdowns.  

With our serious commitment to technology, we have software in-house that allows us to search the universe of mutual funds using virtually any selection criteria we choose.  We can “dial-in” those funds that meet our specific performance requirements.

Once a number of potential candidates are identified, we then run various combinations of these funds inside a single portfolio, in an effort to further enhance potential performance and reduce the risk of loss.  We call these different groups of funds our Absolute Return Portfolios.

All of the mutual funds we have selected have some measure of active management as part of their strategies.  Investors who wish to take advantage of the Absolute Return Portfolios will have the choice of three different risk levels – Moderate, Moderate-Plus and Aggressive.  There is a slightly different mix of funds (5-6) in each category, but the objective is to produce attractive absolute returns.

We continually monitor the funds making up each Absolute Return Portfolio, and we have the authority to add, drop or replace a fund within a particular Portfolio, should that become necessary in the future.  Factors that might cause a fund to be dropped from a Portfolio include, but are not limited to: the loss of a key manager, regulatory problems, change in the investment strategy, or poor performance.  The key is, we’re watching them every day.

The minimum required to invest in our Absolute Return Portfolios is only $15,000. Individual accounts are opened at T.D. Ameritrade (formerly T.D. Waterhouse) where the funds will be purchased and held. 

As you look at your investment portfolio, view our Absolute Return Portfolios as a key part of a well diversified strategy.  Within that strategy, you would have an allocation to “active” managers that can hedge or move to cash if need be, such as those I recommend.  And you would have an allocation to our Absolute Return Portfolios, which have delivered good returns in up OR down markets.

As always, it is also important to remember that, while these funds have posted consistent positive returns in the past, there is no guarantee that they will do so going forward.

Conclusions

As a contrarian by nature, it concerns me anytime I see the investment public loading up on any particular market sector, as we are now seeing with international equity mutual funds.  The public is usually very late to the party.  This could be especially true if the US economy disappoints over the next few quarters as BCA predicts.

I continue to recommend that you have a significant allocation of your portfolio with “active” money managers that have the flexibility to “hedge” or move to cash if market conditions so warrant.  I also recommend having money in our Absolute Return Portfolios that have demonstrated the ability to provide good returns in up OR down markets.  As always, past results are not necessarily indicative of future results.  Call us for more information.