The US economy rebounded strongly in the 4Q of last year according to the latest GDP report from the Commerce Department.  Gross  Domestic Product rose a surprising 3.5% in the 4Q, following 2.0% in the 3Q and 2.6% in the 2Q.  The rise in the 4Q was well above pre-report expectations.  Several other economic reports released in the last couple of weeks were also quite positive and above expectations.  The manufacturing sector is heating up, and even the housing market yielded some positive news in the latest reports.  The latest economic reports confirm what Ihave been telling you for much of the last year - specifically that the US economy is not headed for a recession this year.  The gloom-and-doom crowd has been wrong once again.

The Fed left interest rates unchanged for the fifth consecutive time in late January, despite the strong uptick in the economy.  A big reason is the fact that inflation fears are moderating, another prediction I have made for the last several months.  The CPI “core rate” of inflation rose only 1.4% for all of 2006, and the GDP inflation index rose only 0.1% in the 4Q.  This news certainly influenced the Fed’s latest decision to leave interest rates unchanged.  With the improvement in the inflation numbers, Ibelieve the Fed could leave interest rates unchanged for an extended period of time.  More details inside.

The US equity markets continue to move higher, despite a great deal of skepticism by many investors.  A big reason for the continued rise in US equity prices is the fact that global liquidity is soaring.  There is a sea of money, especially in Asia and in oil-producing nations that is looking for a home, and the US equity markets are increasingly the beneficiaries.  This is one reason  the US stock markets could enjoy another positive year. 

On the political front, we will discuss what would likely happen if the Democrats roll back President Bush’s tax cuts, as is looking more and more likely, and why this is an important issue to all investors.  We finish up this month with a discussion on how to get hedge fund-like returns in your portfolio.  You may be surprised to learn that some of the professional money managers I recommend use strategies that are very similar to those used by some of the most popular hedge funds.

The Commerce Department, which gauges the ebb and flow of the US economy, released its first estimate of 4Q GDP last Wednesday.  The "advance" GDP report showed that the economy surged ahead by 3.5% in the 4Q of last year, well above most anal-ysts' pre-report estimates.  This compares to the 3Q when GDP rose only a tepid 2.0% and the 2Q rate of just 2.6%. 

For all of 2006, the economy expanded at the annual rate of 3.4% according to the latest Commerce Department report.  Not too shabby, especially when you compare that to what the gloom-and-doom crowd and many Democrats wanted us to believe last year.  But what else is new?  The economy is being driven by the strong jobs market, despite the slight uptick in the unemployment rate for January to 4.6% from 4.5% the previous month. 

There were several encouraging economic reports released in January.  The Index of Leading Economic Indicators rose 0.3% again in December (latest data available).  The ISM manufacturing index rose from 49.5 in November to 51.4 in December.  Durable goods orders rose 3.1% in December following a gain of 2.2% in November.  Industrial production rose 0.4% in December following a decline of 0.1% in November.  Things are definitely looking up in the manufacturing sector.

The rebound in the economy was led by - surprise, surprise - a surge in consumer spending in the 4Q.  Despite the reports we've heard about the disappointing holiday shopping season, it turns out that retail sales actually rose by a solid 0.9% in December versus November, and that does not include the growing "gift card effect" as I will discuss below.  For all of 2006, retail sales rose by 6.0% over 2005 levels, according to the Commerce Department.

The fact that consumers sparked another jump in the economy should not come as a surprise to unbiased observers.  The Consumer Confidence Index rose again in January by 0.3%, following a large increase in December.  The University of Michigan's Consumer Sentiment Index also surged from 91.7 in December to 96.9 in January.  Consumer confidence has risen significantly from its low point in August of last year. 

As for the so-called 'gift card effect,' this refers to the increasingly popular trend of giving pre-paid gift cards from various retailers and malls during the holiday season.  According to the National Retail Federation, gift card purchases in 2006 hit a new record of $27.8 billion, well above the projected target of almost $25 billion, and well ahead of the $18 billion spent on gift cards in 2005.

Interestingly, retailers are not allowed to record the sale when a gift card is purchased; rather, the sale is recorded when the recipient redeems the card to make the actual purchase of goods or services.  Thus, the record large gift card sales during the holiday season may actually serve to boost the economy in the 1Q of this year, even though the cards were purchased last year.

On the housing front, the latest news was mixed, but on the whole positive.  While sales of existing homes fell slightly in December, new home sales actually increased in December.  Housing starts also rebounded in December, as did applications for new building permits.  The housing sector is not out of the woods by any means, but the latest reports suggest the industry is at least stabilizing on a national basis.

Not A Surprise To My Readers. . .
So Much For The Gloom-And-Doomers

The stronger than expected GDP report last week came as a big surprise to the gloom-and-doom crowd that had promised we were headed into a recession or worse in 2007.  As you might expect, the perma-bears heard the news of the stronger than expected economy and immediately began to warn that the Fed would surely hike interest rates as a result.  They didn't!  As I will discuss below, the Fed voted unanimously last Wednesday to keep short-term rates unchanged at 5.25% for the fifth consecutive time.

Over the last year, I have consistently advised you that the economy was going to experience a nominal slowdown for 2-3 quarters, with a rebound to unfold in 2007.  I have consistently advised that a recession was not the most likely scenario.  Based on the 4Q GDP report, it looks like the recovery is taking hold even earlier than I thought, although it would not surprise me to see something a little less than 3.5% growth in the 1Q of this year

Over the last year, I have also predicted that the US equity markets would continue to trend higher, and they have.  The Dow Jones continues to make new record high after new record high.  The broader S&P 500 Index has yet to make a new record high, but it continues to move higher, delivering a total return (including dividends) of 15.79% for 2006. 

I hope you dismissed the gloom-and-doom crowd and took advantage of my advice over the last year!  That is not to say that the gloom-and-doom crowd won't have their day at some point.  They will.  The only question is when.  In the meantime, the US economy has surprised on the upside for the last 20+ years, and I don't think the run is over just yet.

Fed Leaves Interest Rates Unchanged Again

The Fed Open Market Committee met in late January, and for the fifth consecutive time, elected to leave the Fed Funds rate at 5.25%, which was widely expected.  Prior to the latest stronger than expected GDP report, many analysts (including me) had been predicting that the Fed would be able to lower short-term rates sometime before the middle of this year.  The Bank Credit Analyst has predicted that the Fed would very likely be able to lower rates more than once this year.

Well, that line of thinking pretty much went out the window with the latest strong GDP report.  Now the thinking has shifted and many analysts fear that the Fed will feel compelled to raise rates in the months ahead.  Several news services described the Fed's policy statement released last Wednesday as "hawkish."  I don't read it that way.  Here are some excerpts from the Fed’s latest policy statement:

Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

This latest policy statement is very consistent with those released following FOMC meetings over the last several months.  In fact, with the exception of one word ("Nonetheless"), the last paragraph of the latest statement is identical to the two prior statements in December and October of last year.  Therefore, I do not consider it to be 'hawkish' or a warning that the Fed is about to start hiking short -term rates anytime soon.

We have come to expect the Fed to continually warn us about inflation, whether or not it is really a significant threat.  While the US inflation rate is still a little higher than the Fed's target, the rate of increase in inflation is slowing.  That is good news.  Let's look at the latest reports on inflation in the US, as they shed some light on the Fed’s latest decision.

The headline Consumer Price Index was up 0.5% in December, while the "core" rate (minus food and energy) was up only 0.2% in December.  For the year, the headline CPI was up 2.5% according to the Dept. of Labor, while the core rate for all of 2006 was up only 1.4%, which is presumably quite acceptable to the Fed.

Another encouraging piece of inflation data was included in last week's GDP report, which almost certainly had a positive effect on the Fed.  The GDP price index for gross domestic purchases by consumers (formerly called the GDP Price Deflator) rose only 0.1% in the 4Q versus 2.2% in the 3Q.  I have no doubt that this indicator was a major reason why the Fed left interest rates unchanged again last week for the fifth consecutive time.

While the gloom-and-doomers and the perma-bears are now warning that the Fed will soon begin to raise short-term rates, I will not be surprised if the FOMC leaves rates unchanged for several more months at least.  The editors at BCA seem to agree:

…Overall [economic] growth seems likely to bounce around its trend level near 3% [in 2007].  That would be a perfect outcome for the Fed and would not warrant a policy response in either direction.

… As always, the trend in inflation is critical to the outlook, because that will be the key determinant of monetary policy.  As long as inflation stays contained, then Fed policy will be on hold, and the economic expansion and equity bull market should continue.

The bottom line is, the editors at BCA see a continued expansion in the US economy, at least for this year.  The risk of a recession in 2007 seems even more unlikely now, especially in light of the strong 4Q GDP report.  Inflation indicators are not rising as much now, so this is another reason to believe that the Fed will not feel the need to raise interest rates anytime soon.

And let's not forget BCA's final note: "…and the economic expansion and equity bull market should continue.”

What Is Driving The US Stock Markets Higher?

I talk to investors just about every day.  The Reps at my company talk to even more investors than I do every day.  The most common question we keep hearing from clients and prospective clients is, what is driving the stock markets higher?

It is easy to be a skeptic of the US stock markets.  For many of us, quite honestly, it is always easier to be a skeptic of the investment markets than being a cheerleader like the always-bullish Wall Street types.  But market skeptics have left a huge amount of money on the table for the last 20+ years, watching and waiting for the market to tank.

Now, here we are in 2007, with the Dow Jones making new high after new high, and yet with all the problems we all see, I am still encouraging you to get off the sidelines and get onboard, especially with the professional money managers and strategies I recommend.  Why?   Let me explain, as succinctly as I can.

The world is awash in liquidity, especially in Asia and the oil-producing nations.  I have discussed this in the past.  Unheralded amounts of money are looking for a place to invest.  If you are a foreign investor, is there anywhere safer to invest than in the USA?  NO.  So, you invest in the US, and where better to invest than the US equity markets?

We can talk about all the problems the US is likely to encounter in the next 5-10 years; we can talk about economic and financial crisis scenarios that could develop; we can talk about social/political/moral issues; etc., etc.  We like to talk about these issues, and we should.

But if you are a wealthy Asian, and you need to diversify your investment portfolio, the United States looks very safe and very good.  End of story.  You get some of your money invested in the US equity markets which have a long history of good returns over time.

The point is, the US equity markets are being driven higher in part by the unprecedented demand for investments in the US.  Forget the usual supply/demand issues we all grew up on.  It's a different time, and the old rules we all learned have changed. 

Understand, it is still supply and demand.  The difference now is that the demand (in this case, money) is coming from all over the world.  Literally, everyone in the know is looking to diversify internationally.  And it's not just Americans anymore.

What this should point out to us, as investors, is that things have changed.  Old models don't work the same anymore.  Simply put, the market equations we learned years ago don't work so well these days.  Things have changed! 

To give you one example, when I cut my teeth in the investment markets, "P/E" ratios and similar indicators were the gold standard.  Just not true anymore. P/E ratios have been out of whack (ie - too high) for years, yet the equity indexes just move to new high after new high.  Something else is going on, as I have suggested above.

Supply-Side Economics & Tax Cuts At Work

There is no question that US consumers have driven the robust economy we have enjoyed over the last 20+ years.  A big factor behind the unprecedented consumer demand we've seen in recent years is the Bush tax cuts.   Now that the Democrats have taken control of both houses of Congress, and very possibly the White House in 2009, the odds of the Bush tax cuts being rolled back have increased significantly.

With that in mind, one of my staff members reminded me of something I wrote in my weekly E-Letter back in 2003 on the subject of the tax cuts.  It deserves revisiting today.  When President Bush took office, he inherited an economy that was falling fast.  The stock market bubble had already started to burst, and the economy was going into a recession. 

At that time, both the Republicans and Democrats floated proposals to help shore up the economy.  President Bush proposed supply-side economics with tax cuts and business incentives, and the Democrats proposed demand-side (Keynesian) government intervention which, in a nutshell, amounted to giving people money to spend to boost the economy.  The Democrats claimed that the tax cuts would do nothing more than reward the "rich" while not having the desired effect of stimulating the economy. 

At the time, I made a prediction as to what I thought would come of the tax cuts.  Here's what I said in my May 27, 2003 E-Letter:

In my January 7, 2003 Forecasts & Trends E-Letter, I compared Bush's proposed tax bill to the one proposed by the Democrats.  In that comparison, I favored the Bush proposal because I believe in supply-side economics.  That's where money from tax cuts is invested in new businesses and expansion of existing businesses.   This creates jobs, and thus increases consumer spending eventually.

The problem with the supply-side story is that this process takes a while.  Many economists have already gone on record to say that the current tax cut will do little to help the economy by the elections in 2004.  I tend to agree, but I continue to believe the economy is recovering - with or without the tax cut.

What bothers me most about the new tax plan, as noted above, are the sunset provisions.  How much of the tax cut will be invested in long-term business opportunities if those who invest do not know what the tax implications of their investment will be when they cash out or start to receive dividends?  As a financial advisor, I would have a hard time advising a client to make a long-term investment that is primarily based on stable tax policy. 

Of course, the Republicans believe that making the tax cuts permanent is just a matter of time.  I don't know that I share their enthusiasm.  Just look at the attempts to make the elimination of the estate tax permanent.  The permanent repeal of the estate tax has not passed yet, and may never do so.

As you can see from the above quote, I strongly believed that the Bush tax cuts enacted would lead to a stronger economy in the future.  The problem was that, at the time, we would have to wait for a period of years to see the economic stimulus come to fruition.  Well, we are now witnessing the restorative effects of the tax cuts, which should put to rest any argument to the contrary.  This is especially true in light of what the economy has had to overcome in the last several years - terrorist attacks, huge federal deficits, an expensive war, soaring oil and other commodity prices, etc., etc.

But now the Democrats are in control.  Will we see them undo all of the good that the Bush tax cuts and other incentives created?  That remains to be seen, but from the talk currently coming from the Democratic leadership, it's definitely a possibility.  While the Democrats may be savvy enough not to raise taxes overtly, there is a good chance they will simply allow the Bush tax cuts to "sunset" in a few years.  That will be bad news for the economy in my opinion.

The bottom line is, we have a great economy today.  In fact, this is the greatest economic boom in history.  It continues to be driven by consumer spending, which is in no small part due to the tax cuts.  But now we have a Democratically-controlled Congress, and we may well have a Democrat president in 2009.  This raises the odds that the tax cuts will go away - one way or the other - in the next few years.

Admittedly, I have taken what was primarily an economic analysis and have now swerved us into a political commentary.  Whenever I write anything political, I get negative comments from some readers who do not share my conservative views.  Yet I have always maintained that politics do affect our investments over the years.

The issue of tax cuts clearly defines why investors should pay attention to politics, as it can and does impact the economy and the investment markets.  This is one reason I will continue to offer political commentaries from time to time, even if they are objectionable to a small subset of my readers.

Politics aside, the economy is rebounding even sooner than expected.  The recession the gloom-and-doomers promised is not playing out.  The equity markets continue to hit new highs, and this looks to continue for a while.  This is precisely why I have consistently urged readers to get back in the equity markets for the last several years. 

But keep in mind that I have suggested that you do so with a significant portion of your portfolio invested with professional money managers that have time-tested systems with the flexibility to move out of the market (partially or fully) or "hedge" positions should we get into bear market cycles or significant downward corrections.

Getting Hedge Fund-Like Returns

As I am sure most readers are aware, “hedge funds” have been the rage in many investment circles over the last several years, really the last decade.  Hedge funds have exploded from just a few hundred funds in 1990 to reportedly well over 9,000 today.  From a few billion in assets in 1990, hedge funds today have in the range of $1.4 to $2.0 trillion in assets, depending on whose estimates you read.

The point is, hedge funds have become extremely popular as an investment alternative.  Yet hedge funds are often only available to the rich.  For one thing, virtually all hedge funds are private offerings that, due to government regulations, are only available to “accredited” investors, those with net worth in excess of $1,000,000 or $1,500,000 in some cases.  Some hedge funds are only offered to “super-accredited” investors who must have net worth of $5,000,000 or more.

[Interestingly, the SEC is seriously considering raising the accredited investor requirement from $1 million to $2.5 million, perhaps as soon as April.  Personally, I think this is a bad idea that will only further disadvantage average investors and restrict such opportunities to the super-rich.]

In addition, most hedge funds have very high minimum investment requirements.  Since private hedge funds can generally only accept 99 investors (another government regulation), many have minimum investment requirements of $1 million or more just to get in the door, and here we’re usually talking about newer funds; older, more established funds often require $10 million or more to get a slot, if you can get in at all.

The point is, most investors are simply shut-out from the hedge fund world, either because they don’t meet the net worth requirements and/or they can’t meet the huge minimum investment requirements.  So what does that have to do with me, you ask?

Plenty!  Since over 90% of US investors do not qualify for most hedge fund offerings, they spend little, if any, time thinking about why they have become so popular among the wealthy.  Sure, there are some wealthy individuals who buy hedge funds mainly for the “snob appeal,” but  the bulk of wealthy investors invest in hedge funds because of the potential benefits they hope to gain within their overall portfolios.

What may surprise you is the fact that you can access some of these hedge fund-like strategies in your own portfolio, even if you’re not among the super-rich.  The fact is that several of the professional money managers I recommend use strategies that are very similar to many of the most popular hedge funds.  Best of all, most of the money managers I recommend have minimum investment requirements of only $50,000-$100,000 - not the millions required by many hedge funds.

The Case For Hedge Funds
&Alternative Investments

While it’s easy to see how a successful alternative investment strategy might attract some attention based on large annual returns, it’s important to remember that those who invest in hedge funds do not always have chasing returns on their minds when they invest.  As I discuss in my Absolute Return Special Report, many wealthy individuals are primarily interested in reasonable returns, but with a strong emphasis on risk management.  The reason is that many have become wealthy by selling a business or through an inheritance, and they don’t want to take a big chance on losing their nest egg.

Many of these same individuals will include aggressive strategies as part of their overall portfolio, which seems to go against their absolute return goal.  However, this is not necessarily true.  Sophisticated investors know that diversification is an important part of prudent investing, and historically, futures funds, hedge funds and alternative investments provided them the ability to diversify beyond the stocks, bonds and mutual funds available to most investors.

Diversification into alternative investment strategies offered by hedge funds may seem to go against conventional risk management wisdom, but studies have shown effective investment diversification can actually result in lower overall volatility, even when some of the investments in the portfolio might be deemed “aggressive.”

The wealthy also know that the key to successful diversification is to structure a portfolio so that the individual parts are not highly “correlated” with each other.  Correlation is generally defined as the measure of the relationship between two variables.  For example, you might say that there is a high degree of correlation between rain and the presence of clouds.  In an investment context, correlation seeks to determine the extent to which investments move up and down in relation to each other  As you might suspect, there are different kinds of correlation.  You can have positive correlation, where two investments generally tend to move up and down at the same time.  You can also have negative correlation where one asset moves up when another moves down and vice versa.  Most interesting to us, however, are those that have no (or low) correlation.  This means that the two investments’ returns appear to be independent of each other.

Assets that have little or no correlation to the overall stock markets tend to be desirable if other factors such as the level of risk and performance are acceptable to the investor.  That’s because the performance of the uncorrelated asset is generally independent of what happens in the stock markets.  This is why, for example, managed futures programs have been so popular among investors, as they generally have had little or no correlation to the overall stock and bond markets in the past.

Correlation analysis is one of the basic foundations of Harry Markowitz’s work in the 1950s that resulted in what we now call “Modern Portfolio Theory,” or MPT.  While space does not permit me to go into a full description of MPT, suffice it to say that Markowitz determined that the extent to which you can combine investments with little or no correlation can have a positive effect on the overall portfolio’s performance.

Thus, one reason wealthy investors have been including aggressive investments in their portfolios is because, as a general rule, such strategies are not correlated to their other investments.  Another way to say it is that these sophisticated investors deem carefully selected hedge funds and other alternative investments to be a prudent addition to their portfolios based on their risk tolerance and mix of other investments. 

I think the wealthy tended to invest in such programs through hedge funds and other alternative investments because they have previously been one of the few places they could get such sophisticated strategies.  Only in recent years have investment products been developed that allowed money managers the flexibility to include leverage and long/short trading in mutual fund portfolios.  Mutual fund products offered by Rydex, ProFunds and Direxion families of mutual funds have definitely leveled the playing field, allowing many more investors to have the option of leverage and long/short strategies in their portfolios.

Though the playing field is now level, I continue to believe that you should leave investment management in the hands of professionals.  As a practical matter, you can go directly to these specialized funds and trade them yourself.  However, that could be a recipe for disaster.  Without the benefit of a tested strategy, it would be easy to get “whipsawed” by volatile markets, possibly decimating the value of your nest egg.

Conclusions

While hedge funds and many other alternative investments are not available to everyone, you can access hedge fund-like strategies with some of the professional money managers I recommend.  Several of the money managers I recommend use long and short strategies, as do many hedge funds and futures funds.  Several of the managers I recommend use specialized mutual funds to “hedge” their positions during market downturns.  And several have strategies that seek to identify the hottest sectors in the market and trade accordingly, as do many hedge funds.

But you don’t have to be a wealthy accredited investor to access the money managers I recommend.  Most have minimum account requirements of only $50,000-$100,000.  If you would like more information on these professional managers, call us at 800-348-3601 or visit my new website on the Internet at  www.halbertwealth.com.