The Commerce Department estimates that 3Q Gross Domestic Product slowed to an annual rate of only 1.6%, down from 2.6% in the 2Q   and 5.6% in the 1Q.  The latest GDPreport was well below expectations, as well as the consensus view that the economy will grow by around 2.5% in the second half of this year.  Other economic reports released over the last month were mixed but generally confirm that the economy is slowing a bit more than expected; however, I continue to believe we will avoid a recession, and that the economy will rebound next year.

Of course, a lot depends on the housing market, which weighed heavily on the latest disappointing GDPreport.  Home prices continue to fall in many parts of the country, and the inventory of unsold homes continues to rise.  Expect this to continue for a while longer.  Icontinue to believe the housing market is in a correction rather than a major bust.

The latest disappointing GDP report makes it much more likely that the Fed is finished raising interest rates, and that we should expect the Fed to begin cutting rates early next year.  The Bank Credit Analyst continues to predict that we will see several rate cuts next year, which will contribute to an economic rebound in the second half of 2007.  The bond markets have rallied strongly on the news that the economy is slowing.

The stock markets have continued to rise, not only in the US but also globally, in spite of negative economic reports and despite the fact that the Democrats regained majority control of the House of Representatives.  I continue to believe we are overdue for a downward correction in the equity markets, but that remains to be seen.  In any event, risks are rising and volatility is likely to remain quite high in the equity markets.

With that forecast in mind, I will introduce newer readers (and reintroduce long-time readers) to one of my favorite professional money managers  Potomac Fund Management.  Potomac has an outstanding long-term performance record, with low drawdowns, and a consistency we’d all like to be able to accomplish on our own.  For a limited time, my clients can still invest with Potomac for only $25,000 (going up to $50,000 in 2007).  Past results are not necessarily indicative of future results.

Introduction

In this month’s issue of Forecasts & Trends, we will review the latest economic data, most of which was disappointing, and I will give you BCA’s latest forecasts.  We will also contemplate what the Fed’s next move is likely to be in light of the latest economic news. 

I will also attempt to explain why the stock markets have been so strong despite the election and the Democrats’ return to power in the House.  But I would not rule out a “hangover” for stocks in the weeks just ahead.  As you will see, the scenario I foresee makes a compelling case for adding Potomac Fund Management to your portfolio now, if it is suitable for your investment goals and risk tolerance.

Economic Growth Looks To Slow A Bit More

Regular readers of this newsletter know that I have been predicting a slowdown in the US economy since the early part of this year.  But I have also predicted that a recession is not the most likely scenario, and that the economy is likely to rebound in the second half of 2007 if not sooner.  As always, the gloom-and-doom crowd, and their accomplices in the mainstream media, continue to predict an economic recession, or worse.  

The latest economic reports have been mostly on the negative side.  As noted on page one, the government reported that 3Q GDP was up only 1.6% (annual rate), well below the 2.6% in the 2Q and  5.6% in the 1Q.  The housing slump weighed heavily on the economy in the 3Q. 

On the positive side, the ISMmanufacturing index rose unexpectedly in October, surging from 53.7 to 57, well above expectations.  This is perhaps the best economic news we’ve seen over the last month.  

Here are highlights of the latest economic reports for September (latest data available).  The Index of Leading Economic Indicators (LEI) rose 0.1% in September.  As I discussed in my October 3 E-Letter, the LEI is not trending significantly one way or the other this year, as evidenced by the incremental rise in September.

The factory operating rate (capacity utilization) eased marginally lower again in September to 81.9%, down from 82.5% in August.  And industrial production fell 0.6% in September, a bit more than expected.  Yet construction spending rose unexpectedly by 0.3% in September.  Mixed signals, more negative than positive, but still no sign of an impending recession.

On the consumer side, retail sales fell 0.4% in September, in line with expectations.  Early indications are that sales rebounded in October.  The University of Michigan’s Consumer Sentiment Index jumped to 93.6 in October, up from 85.4 in September.  Durable goods orders for September were surprisingly strong, up 7.8%, due to a big jump in aircraft orders.  Minus aircraft orders, durable goods orders rose only 0.1%.

The latest numbers on housing were mixed.  Housing starts surprised on the upside in September, while home building permit applications were lower than expected.  Existing homes sales for September were down 1.9%, in line with expectations.  The median sales price for existing homes dropped for the second month in a row to $219,800.  On the bright side, new home sales rose 5.3% in September, well above expectations.  Overall, the housing slump continues, but so far it has not turned into the bust that so many have predicted.

Fed Leaves Rates Unchanged

The Fed Open Market Committee voted to leave interest rates unchanged for  the third time on October 25.  The Fed’s last policy meeting of the year is scheduled for December 12, and Wall Street is hoping for a cut in the Fed Funds rate at that time. 

On the inflation front, wholesale prices fell sharply in September (-1.3%), led by plunging oil prices.  It was the largest monthly decline in over three years.  The Consumer Price Index also fell 0.5% in September.  However, the “core rate” (minus food and energy) still rose 0.4% for wholesale prices and 0.2% for consumer prices.

As we have discussed often in the past, the Fed is believed to focus much more on the core rate of inflation rather than the headline numbers.  Since the core rate is still above the Fed’s target, the Fed  left rates unchanged on October 25, rather than opting for a cut.  What the Fed decides to do at the December 12 meeting will depend on the economic and inflation reports between now and then.

Dow Finally Closes Over 12,000 – Now What?

The DJIA finally managed to close just a hair over the 12,000 mark in late October and is holding above that level as this is written.  I don’t remember this much hype and media attention over the equity markets in many years.  Predictably, new money is flooding into equity mutual funds.  September purchases of mutual funds were the second highest of the year, and I will venture to predict that October purchases will be even higher.  Hot money is flooding back into equities.

While a new record high in the Dow is indeed impressive, the risks of being in the market are definitely increasing in my opinion, especially with the slower than expected 3Q economic data and the House of Representatives falling to the Democrats.  With the economy slowing down more than expected, the meteoric growth in corporate earnings seen over the last few years is on course to slow down as well.  On this note, The Bank Credit Analyst offered the following warning in October on the day the Dow closed over 12,000:

“The unfolding global economic slowdown indicates that the robust earnings growth of the past three years will soon fade. Indeed, analyst earnings revisions are already declining and further cuts seem likely.”

BCA continues to believe that equity prices will trend somewhat higher over the next year or so but not without some potentially scary downward corrections along the way.  I will not be surprised if we see a downward correction in the equity markets in the next few weeks as the latest economic data and the election results start to sink in.  Don’t forget that the much broader S&P 500 Index has not reached a new high, and if it fails to do so just ahead, we could see a potentially nasty sell-off in equities between now and the end of the year.

For all these reasons, I believe the risks in the equity markets are increasing, just at the time that large numbers of investors are pouring back into the markets.   What else is new? 

If I were a trader, I would be looking to take some money off the table at this point.

Most of us are not traders, however.  For this reason, Wall Street preaches “buy-and-hold” but this strategy subjects investors to the periodic large drawdowns that inevitably occur.  In the bear market of 2000-2002, the S&P 500 Index plunged over 44%, and many investors bailed out and have never gotten back in.  That is a major risk with the buy-and-hold strategy.  This is precisely why I favor “active management” strategies which have the flexibility to move out of the market, or hedge positions, during market downturns.  

With that in mind, let me introduce (or reintroduce) you to one of my all-time favorite money managers, one that has successfully managed the risks in the markets for many years.  Now might be a very opportune time to consider getting this very successful money manager on your team, especially while you can still invest for only $25,000 rather than their new  $50,000 minimum account requirement.

Potomac Fund Management, Inc.

Potomac Fund Management is a Registered Investment Advisor with the SEC and is located near Washington, DC.  I have had a portion of my personal equity portfolio allocated to Potomac for over a decade.  What I like about Potomac Fund Management (PFM) is their long record of delivering attractive rates of return.  What I like even more is how they manage risks when the markets go down.  As you can see in the table below, PFM’s Guardian Program has delivered average annual returns of over 11% with a worst-ever losing period of only –8.1%, and they’ve done it for over a decade in good markets and bad.  Past results are not necessarily indicative of future results.

PFM invests in a wide range of mutual funds, using a very sophisticated system to select which funds to be in, when to be in them, and when to move to cash or hedge positions in their effort to avoid large losses.  Take a close look at the performance numbers on the next page.  Keep in mind that these are actual results, net of all fees and expenses. 

When I look at Potomac’s past performance record, I think it embodies the type of investment returns we all wish we could do on our own: good returns with very low drawdowns.  

Unfortunately, most investors can’t duplicate these steady returns, especially when bear markets like 2000-2002 come along and the S&P 500 plunged over 44%.  While buy-and-hold investors were getting hammered in 2000-2002, PFM protected its assets, avoided the big losses and even made some money. 

You can see why I have a chunk of my own money with PFM.  In fact, I am in the process of more than doubling my investment with Potomac.  Now may be a good time for you to get started (or add to your own account if you already have one).

Getting Potomac Fund Management On Your Team

The way you get PFM on your team is simple.  With assistance from my company, you open your own account at Fidelity Brokerage.  PFM is given written authority to buy and sell mutual funds in your account.  PFM selects among the hundreds of funds it considers and monitors them accordingly.  Fidelity provides a detailed monthly account statement showing all activity in the account.  You can add to or close the account at any time.

PFM charges an annual management fee of 2.5% on amounts up to $100,000 and as low as 1.25% on amounts above that level.  PFM shares a portion of its management fee with my company for introducing the account and our ongoing client relationship.  The management fee is exactly the same whether you engage PFM through my company or you go to PFM directly.  (FYI, all performance figures quoted herein are net of all management fees and expenses.)

As you can see in the performance statistics and chart on the following page, Potomac has delivered very impressive returns, with very small drawdowns along the way over the last decade - and this includes both up and down markets.  (Past results are not necessarily indicative of future returns.)

Best of all, PFM recently increased its minimum account requirement to $50,000, but my clients and readers can open accounts with PFM with only $25,000 for a limited time through year-end.  If you are ready to get started, call us at 800-348-3601 to request account applications and more detailed information on the program.  You can also request more information on Potomac on our website at www.profutures.com.

With those highlights noted, let me give you more details on Potomac Fund Management and their very successful investment program.  

The Story On Potomac Fund Management

Potomac Fund Management, Inc. is a Registered Investment Advisor with the SEC and is located in historic Easton, Maryland, near Washington, D.C. Founded in 1987, the firm has since grown to manage over $130 million in assets for hundreds of investors, and employs a growing number of investment professionals and administrative staff.

Potomac’s investment strategy is primarily “technical” and has evolved over time as continuing research has led to enhancements. There are three main components of the strategy.  First, research and technical analysis determine whether to be fully invested, partially invested or in the safety of cash (or hedged).  Second, further analysis determines which sectors of the market are selected. Third, additional analysis determines which particular mutual funds are best suited for the current market environment.  This is an ongoing, daily process and Potomac will make adjustments to clients’ portfolios as necessary.

While the technical systems are the driving force, at certain times Potomac’s investment staff will use its years of investment experience to assist in the portfolio decisions. This brings Potomac clients a combination of the discipline of a technical system, and the flexibility of seasoned professional judgment.

Potomac’s “Guardian” Program

The goal of Potomac’s Guardian Program is to deliver consistent positive returns with an emphasis on reducing volatility.  Potomac seeks to maximize risk-adjusted returns by employing an active management strategy that is longer-term than most. The trading model seeks to allocate investments across many sectors and/or asset classes, overweighting those Potomac deems to have the best risk-to-reward ratio.  While there is no guarantee that this goal can always be met, Potomac has been one of the steadiest money managers I have ever seen in the 12 years Ihave been tracking active managers.

Potomac may include both domestic and international stock and bond mutual funds, as well as funds designed to track certain stock and bond market indexes.

If the trading model forecasts a market downturn, Guardian can hedge positions or move fully or partially to cash, though 100% cash allocations are rare. Guardian attempts to further control risk through its mutual fund selection process. Potomac screens the entire universe of funds, looking for those with a history of strong performance during both bull and bear market periods.

With this focus on potential risk-adjusted returns, Potomac rarely finds it necessary to frequently move in and out of the market. This is beneficial in that it reduces the chances of being “whipsawed” by frequent short-term changes in the market's direction. It is also an advantage in light of the fact that many mutual funds are charging “early redemption” fees if funds are not held for a minimum period of time.

In situations where Guardian signals a move to cash prior to the expiration of a fund’s minimum holding period, Potomac can use mutual funds designed to “short” the stock market in order to hedge long positions, rather than liquidating them and incurring early redemption fees.

Performance Evaluation

As clients and regular readers of this newsletter know, one of the first criteria I use to evaluate any money manager is risk control. Did they preserve assets in a down market?  While buy-and-hold strategies typically incur large losses in bear markets (S&P 500 down 44% in 2000-2002), a good actively-managed investment program should deliver “absolute returns” (positive returns in up and down markets). And PFM has certainly delivered. 

The second criterion I use is overall volatility. How was the performance delivered? Were there just a few large market uptrends that provided the profits, or were there consistent monthly gains? Ditto for the losses along the way.  You have to research the performance data very carefully, both on the upside and the downside.

Potomac Guardian has delivered very impressive annualized returns after all fees and expenses, without the kind of downside volatility that many other stock market investments have suffered. As noted in the performance table above, PFM’s annual average return was over 11%, with a worst-ever losing period of only –8.1%, versus –44% in the S&P 500.  This is a rare accomplishment!  Of course, past results are not necessarily indicative of future results.

Guardian’s real objective, as noted above, is to deliver absolute returns with lower risk. Why is this so important? Studies have shown that many investors don’t reach their goals because they get uncomfortable during losing periods and give up. The Dalbar studies and others find that investors frequently give up and sell at or near the bottom of market cycles - and later end up buying back in near the highs (a phenomenon we may be seeing today). 

I believe most investors would be better served by an actively-managed strategy like Potomac Guardian which has delivered impressive returns without the large drawdowns – including the bear market of 2000-2002. 

Reporting & Management Fees

As noted above, customer accounts are held in the custody of Fidelity Brokerage. Each month, you receive a detailed account statement from Fidelity showing all activity in the account. You can access your account daily at www.fidelity.com.  You add to your account, or close it, at your discretion.

PFM charges an annual management fee of 2.5% for the first $100,000, and as low as 1.25% on amounts thereafter.  A portion of the management fee is shared with my company for introducing the account and our ongoing client relationship. The management fee is the same whether you access PFM through my company or go to them directly. (FYI, all of the performance statistics in this report are after all fees and expenses were deducted.)

Conclusion

It should be obvious by now why Potomac Fund Management is one of my favorite money managers.  With average annual returns over 11% and with a worst drawdown of only -8.1% - for over a decade – the Potomac Guardian program is indeed impressive.  While past results are no guarantee of future performance, PFM has demonstrated that it can deliver absolute returns with lower risk than many other traditional stock market strategies.

Given that risks in the stock markets are increasing, and given that we are probably overdue for a correction in the market, now may be a good time to invest with Potomac.  As noted earlier, I am in the process of doubling my investment with Potomac, which is a testament to the level of confidence I have in the firm.

Best of all, you don’t have to have a million dollars to invest with PFM.  The minimum investment is only $50,000 and my clients and readers can invest for a limited time with only $25,000 until the end of this year.  This is our last opportunity to offer PFM at this lower minimum.

If you are ready to consider an actively-managed investment for a part of your portfolio, then I highly recommend that you consider Potomac Fund Management seriously, if it is suitable in terms of your financial situation and risk tolerance. Be sure to read the Important Notes & Disclosures on the following page.

If you are ready to get started or have questions, call us at 800-348-3601. One of our Investment Consultants will be glad to help you.  You can get your Potomac account open and investing within a week or so.  Don’t procrastinate.

IMPORTANT NOTES & DISCLOSURES

IMPORTANT NOTES FOR POTOMAC GUARDIAN PROGRAM:  Halbert Wealth Management, Inc. (HWM) and Potomac Fund Management (PFM) are Investment Advisors registered with the SEC and/or their respective states.  Some Advisors are not available in all states, and this report does not constitute a solicitation to residents of such states.  Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed.  Any opinions stated are intended as general observations, not specific or personal investment advice.    Please consult a competent professional and the appropriate disclosure documents before making any investment decisions.  There is no foolproof way of selecting an Investment Advisor.  HWM receives compensation from PFM in exchange for introducing client accounts to the Advisors.  For more information on HWM or PFM, please consult the appropriate Form ADV Part II, available at no charge upon request.  Any offer or solicitation can only be made by way of the Form ADV Part II. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor's 500 Stock Index and the NASDAQ Composite Index (which include dividends) represent unmanaged, passive buy-and-hold approaches.  The volatility and investment characteristics of the S&P 500 or the NASDAQ Composite may differ materially (more or less) from that of the Advisor.  The performance of the S & P 500 Stock Index (with dividends reinvested) and the NASDAQ 100 is not meant to imply that investors should consider an investment in the Potomac Guardian trading program as comparable to an investment in the "blue chip" stocks that comprise the S & P 500 Stock Index or the stocks that comprise the NASDAQ 100.

Potomac's performance results are based on the Model Portfolio.  The Model Portfolio is an actual account that is considered representative of the majority of client accounts with similar investment objectives.  Returns for the Model Portfolio are time-weighted, total returns that reflect the reinvestment of dividends and capital gain distributions.   Historical performance data was provided by the Advisor and where possible reviewed by HWM from selected customer account statements and/or independent custodian statements.  However, since only selected accounts were analyzed there can be no assurance that the performance in these accounts was consistent with others.   Statistics for "Worst Drawdown" are calculated as of month-end.  Drawdowns within a month may have been greater.  PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.  Any investment in a mutual fund carries the risk of loss. Mutual funds carry their own expenses which are outlined in the fund's prospectus.  An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results.  The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Potomac Guardian's trading program.

In addition, you should be aware that (i) the Potomac Guardian's trading program is speculative and involves a moderate degree of risk; (ii) the Potomac Guardian's trading program's performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) PFM will have trading authority over an investor's account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Potomac Guradian's trading  program's expenses will reduce an investor's trading profits, or increase any trading losses.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees.  They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable.  All dividends and capital gains are reinvested.  No adjustment has been made for income tax liability.  Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss.  The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.

Copyright © 2006 Halbert Wealth Management, Inc.  All Rights Reserved.