ECONOMIC & INVESTMENT OVERVIEW

The latest economic data confirms that the economy is slowing down, but is still in positive territory.  In its first estimate, the government said GDP grew at an annual rate of only 1.1% in the 2Q.  They also revised 1Q growth from 6.1% to 5.0%.  They also revised the figures for 2001, showing that we, in fact, had three out of four negative quarters last year.  This confirms, finally, that the recession was real.

The latest economic data increases the odds that we will have a "double-dip" recession.  With the economy growing only slightly (+1.1%) in the 2Q, and with the latest plunge in the stock markets, we could very well see negative growth in the 3Q.  Consumers are in a funk as a result of the stock market dive, and this could be enough to send the economy into negative territory this quarter.  What happens beyond the 3Q is largely dependent on whether or not the equity markets stabilize and begin to recover.

The equity markets reached their lows on July 23, with the Dow down 34%, the S&P 500 down 48% and the Nasdaq down 76% from their peaks in 2000.  The markets have rebounded sharply from those levels, but it is still unclear whether stocks have seen the bottom.  Starting in mid-August, CEOs and CFOs will have to certify (sign) their company financials, and there are rumors that some of these executives are going to refuse to sign them.  If this is true, the markets could be in for another pummeling.  We just have to wait and see.

The corporate reform bill sailed through Congress, and President Bush signed it into law on July 30.  While many of the provisions in this new law will be helpful, it is not a panacea for the industry.  Most notably, the new law is silent regarding stock options, which are a large part of the accounting problems.

Bonds have benefitted from the plunge in the stock market.  Yet many investors don't understand that bonds can be even more volatile than stocks.  This month, I introduce you to a new money manager who has an outstanding system for timing bond funds and a very impressive 10-year track record.  Be sure to read this month's issue of Professional Investing.

The Economy - New Figures Show Growth Is Slowing

The Latest GDP Figures

The latest economic reports by the Commerce Department confirm what many people had thought: that the economy was not really growing as fast as government reports had earlier suggested.  On July 30, the Commerce Department reported that GDP rose by only 1.1% (annual rate) in the 2Q.  The average pre-report estimate by analysts and economists was 2.3%, so the news was disappointing.

The Commerce Department also revised downward its report on 1Q growth.  That report was revised from 6.1% to only 5%.  While this revision was treated negatively in the media, it's still an impressive number nonetheless, especially coming only months after the September 11 attacks.

The latest GDP report also included some downward revisions for 2001.  The Commerce Department revisions show that the economy did contract in the 1Q, 2Q and the 3Q of 2001.  That settles the question of whether we did or didn't have a recession in 2001.  A recession is widely defined as two or more consecutive negative quarters in GDP.

A Double-Dip Recession?

With the latest disappointing GDP report for the 2Q (+1.1%), everyone is wondering if the economy will slip back into negative territory in the 3Q.  Up to this point, the economic reports we saw in July do not suggest, on balance, that the economy is going negative in this quarter.  However, the latest plunge in the stock market could certainly change that outlook. 

The latest GDP report showed that consumer spending fell to 1.9% in the 2Q versus 3.1% in the 1Q.   It doesn't take a rocket scientist to predict that consumer spending will contract even more in the 3Q, if for no other reason than the stock market plunge.  People are scared, and when they are scared, they cut back spending and increase savings.  So, it's not a matter of "if" consumers pull back, it's "how much."

Provided the stock markets stay down, consumers will stay in a funk.  Therefore, it seems likely that the economy will either be flat or down slightly in the 3Q.  The question is, what happens after that?  I think the answer lies in what happens next in the stock markets.  If the markets get worse, I expect that will be enough to  drive the economy into negative territory in the 4Q as well, and that would mean we will have the "double-dip" recession.  On the other hand, if the markets stabilize and improve, even modestly, the economy could begin to grow again in the 4Q and into next year.

I realize that the analysis above is anything but definitive; however, this is the situation we are in.  The stock market is the key at this point.

BCA believes that if the stock market decline accelerates, or if upcoming economic reports are weak, the Fed will step in and lower rates again.  They believe that the Fed understands the risk of a debt-deflation setting in and will not hesitate to act if conditions worsen from here.

This is not to suggest that the equity markets have bottomed.  The markets may yet have to make new lows before the bottom comes.  However, it does suggest that  upcoming weakness, if it occurs, should not be of the magnitude we saw in July.  Barring any serious negative surprises, the markets should bottom and begin to stabilize in the weeks just ahead.

Markets bottom when things look the worst.  Over the past couple of weeks, I have had numerous people who are out of the market ask me what they should do.     My advice has been that they should begin to "dollar cost average" back into the markets in a diversified portfolio.  Begin to put a small part of your money back into the market every month.

Since you will be reading this in the second week of August, you might want to wait until after the middle of the month, when we know if corporate CEOs refuse to sign their financials.  I will discuss that more in the pages that follow.

How Greedy CEOs & Auditors Wrecked The Market

Understanding What Went Wrong

Since last November, when America was still reeling from 911, my best sources believed that the economy would rebound this year.  At that time, when many believed the US economy would be in a recession for most of this year, my sources predicted a rebound in 2002.  Yet not even my sources were able to predict that the economy would rebound at a red hot 5% annual rate of growth in GDP in the 1Q.  But at least they were right about the recession being very mild, and that growth would resume this year.

Once it was clear that the economy had turned the corner, most of the sources I respect also believed that the stock markets would begin to recover as well.  With the economy recovering strongly, with interest rates and inflation very low, and with a ton of liquidity in place, the environment was near-perfect for a rebound in equities.  With few exceptions, the stock markets have historically performed very strongly in conditions such as we saw earlier this year. 

The only caveat my sources offered for their positive forecasts for equities this year was the possibility that another major terrorist attack(s) in the US could throw all their predictions out the window.  We all saw what happened in the equity markets after 911, so it was perfectly understandable to most investors that forecasters would make their predictions subject to another major terrorist attack.  So far it hasn't happened.

Then Came Enron

On December 2nd, Enron filed for bankruptcy to the surprise of analysts and investors around the globe.  The Houston-based energy trading giant admitted to billions of dollars of losses, mis-stated earnings and accounting scandals.  Bankers, stock analysts, auditors, and Enron's own board failed to understand the risks and mismanagement in this heavily leveraged trading giant.  Enron's bankruptcy filings showed $13.1 billion in debt for the parent company and an additional $18.1 billion for affiliates.  But that didn't include at least $20 billion more estimated to exist off the balance sheet.  At the time, Enron was the largest corporate bankruptcy in US history.  We were all shocked to learn that not only were Enron's top executives in on the massive scam, but so were their auditors, the now defunct Arthur Andersen.

When Enron went down, I assumed this was an isolated case.  It was, after all, a highly leveraged commodity (energy) trading company.  At the time, I figured Enron had let its energy trading get out of control and the market had simply gone against them.  As it turned out, Enron's troubles were far more widespread than trading losses.  In fact, as best as I can tell, Enron's core energy business was still profitable.  The problem was, there was massive financial fraud committed by its senior executives, which was signed-off on by its auditors, Arthur Andersen.

Maybe I Was Just Naive

I work in a very heavily regulated business, just as Enron did.  ProFutures is regulated by the:

            Securities & Exchange Commission

            National Association of Securities Dealers

            Texas State Board of Securities

            US Commodity Futures Trading Commission

            National Futures Association

Because we have clients in all 50 states, we are also subject to the securities rules and regulations in each of these states.  On any given day, these regulators can call and tell us they are coming in for a regulatory "examination," or what we call an "audit," at the time of their choosing.  Or, they can just show up, unannounced, without any notice.  They can stay as long as they want, and they can look at any records they want.  We typically have one of these audits every year, or at least every other year, by one or more of these regulatory bodies.  We have been audited by every one of the regulatory agencies listed above.

We keep very good records; we run a very clean shop; and these audits usually end earlier than expected.  I can't say that I like these audits by the regulators, as they are very time consuming, but I can say that we learn how to better comply each time they come in.

At ProFutures, in addition to the regulatory oversight, we are also required to have all of the funds we control (Diversified Fund, etc., etc.) audited each year by an independent CPA firm.  These CPAs must sign a cover letter to their audit (Annual Report) that is required to be sent to all of our investors in our funds, stating that the assets we report are really there.

Interestingly, our independent CPA is not on a consulting contract with us and never has been.  In fact, they have made it clear over these many years that they would not be a hired consultant to us, nor would we have wanted them to be.  There was never any need on our part, and there was never any desire or willingness on their part.  We always knew the potential conflicts of interest, and we never entertained going there.

Pardon me if this explanation of our regulatory environment and accounting procedures bored you, but it was in this context that I figured the Enron debacle was probably an isolated event.  I did not consider that there might be dozens (or more) CEOs and CFOs in major corporations that were willing to risk going to jail by cooking their books.  Like ProFutures, publicly-traded companies are also heavily regulated.

More importantly, I did not consider that one of the largest accounting and consulting firms in the world - Arthur Andersen - would be in cahoots with Enron.  Sorry, but given my relationship with my CPAs, and my years of working in a highly regulated industry, it just didn't cross my mind.

The "Armani" Terrorists

Virtually everyone who predicted that stocks would go higher this year emphasized, as noted earlier, that their forecasts were contingent on there being no more major terrorist attacks in the US.  Yet these massive accounting and financial scandals are nothing short of corporate terrorism.  I call them the "Armani" Terrorists, referring to their $2,000 Armani suits and bloated salaries.

We now know that numerous highly paid CEOs  juiced up their books in an effort to keep their profits at attractive levels.  Because of lucrative stock options, many CEOs were apparently willing to risk jail time by means of questionable and/or illegal accounting practices.  And not just CEOs were to blame, as stock options spread among many high level officers and employees who would have a say in how the books were maintained.

Not to be overlooked, the accountants were also at fault.  Instead of stock options, they had lucrative consulting deals that hinged on their ability to make the books look good.  In order to continue generating huge fees on the consulting side, the auditors agreed to sign off on the financial statements despite the questionable and/or illegal accounting practices.

In a way, it was the same as those large wire-house brokerage firms whose investment banking divisions had conflicts of interest with their analysts and their brokers.  The investment banking arms were underwriting companies that they knew were losers.  They promoted them to their analysts and brokers on the retail side who then touted them to their customers.  Almost every major brokerage house is now under investigation for this.

The result?  The stock market and possibly the economy have been blindsided by corporate terrorism.  These Armani Terrorists are not motivated by anything like religious fanaticism.  It's just plain old greed and a lack of morals!

For some time before the latest problems, we saw CEOs who were routinely paid bonuses even though their companies lost money.  This was not just prevalent in the "dot.coms" where they got paid for click-throughs ("hits") on their website, but also in traditional brick-and-mortar businesses, that felt they had to pay through the nose to get the "top talent."  Compensation for CEOs and other officers skyrocketed in recent years, including the rampant use of stock options, which I will discuss later. 

Each year, Forbes lists the highest paid CEOs in the country.  The list on the following page shows you what the top CEOs will make this year.

Top Paid CEOs In 2002

            Oracle                          $706 million

            Dell                              $202 million

            JDS Uniphase               $151 million

            Forest Labs                 $148 million

            Capital One Fin.           $142 million

            Nabors Industry          $124 million

            Lehman Brothers         $115 million

            Quest Comm.               $102 million

            Stilwell Financial           $93 million

            Siebel Systems             $88 million

Remember, this is their projected compensation for 2002 only.  These figures represent salaries, bonuses and stock options, which I will discuss later.

As compensation has skyrocketed, CEOs have become celebrities and "legends in their own minds."  Many were reaping huge rewards and pay increases, even though their companies were/are performing poorly, which often led to huge layoffs of employees to cut costs.  The buck didn't stop with them; it didn't even stop anywhere near them.  Why should it?  They were not mere mortals, they were CEOs.

In most cases, the only way the CEO could be bumped off was if the stock price started to falter.  So, by learning how to cook the books (with the aid of their friendly auditors), they learned how to keep their jobs and become even bigger celebrities.

Toxic Stock Syndrome

These shenanigans worked well, apparently, in the bull market.  But as the markets turned lower, the accounting gimmicks couldn't hide the abuse and fraud.  As you know, we've now seen several major corporate bankruptcies, and dozens of companies are now under scrutiny for questionable accounting practices.

All of this has driven the markets over the cliff.  The worst day in the markets came on  July 23.  At the close that day, the Dow was down 34.3% from its peak; the S&P 500 was down 47.78% from its high; and the Nasdaq was down 75.66% from its lofty peak in 2000.

As I wrote in Special Update #30 (my e-mail newsletter) on July 26, the current decline is far greater in magnitude than the  October 1987 crash.  Millions more people are in the market today versus in 1987.  From the peak in 2000 to the low in July, the combined loss in equities is estimated at more than $8 trillion!

Investors have now become very skeptical of anything reported by the companies.  Many have decided to cash-out their stocks and mutual funds and move to bonds or cash.  While mutual fund redemptions have increased significantly, there has not been what I would call a "stampede" out of the market.  That may yet happen, however, if there is more bad news on the accounting and financial reporting front.

The Corporate Reform Bill

Prodded into quick action by the growing accounting scandals, the House and Senate approved a bill intended to rein-in corporate wrongdoers and toughen oversight of the beleaguered accounting industry on Thursday, July 25.  The House vote was 423-3.  The Senate vote was 99-0.  Those voting against it were Reps. Michael Collins of Georgia, Jeff Flake of Arizona and Ron Paul of Texas.

President Bush signed the bill into law on Tuesday, July 30.  Among other things the new law:

• Calls for a stronger, five-member accounting oversight body with the authority to investigate and punish accounting firms, funded by publicly-held companies and overseen by the SEC;
• Significantly increases the Securities and  Exchange Commission's budget to $776 million for fiscal-year 2003 for improving technology, providing raises and increasing staff (accountants and lawyers in particular), and provides the SEC with the authority to bar "unfit" officers from serving on corporate boards;
• Lengthens the statute of limitations on securities fraud to five years, and makes securities fraud a crime subject to a 25-year jail term; 
• Prevents company executives from receiving company loans unavailable to outsiders;
• Establishes an independent review by federal accountants of all public accounting firms that audit more than 100 firms, replacing the peer review process;
• Restricts the consulting services an accounting/ auditing firm can provide its clients;
• Requires that CEOs and CFOs at 17,000 publicly-traded companies certify their financial reports, and punishes those who knowingly falsified records with a maximum 20-year jail term or $5 million fine;
• Prevents chief executive officers from selling stock during "blackout periods";
• Makes it easier for whistleblowers to sue.

On balance, the new regulations, restrictions and tougher penalties sound good.  However, we should all understand that these new requirements will increase corporate expenses in order to comply, and likely decrease earnings.  With P/E ratios still at very high levels, this could mean they get even higher.

Furthermore, it is possible that corporate managers will become so gun-shy that they purposely understate revenues and earnings.  As noted above, under the new law, CEOs and CFOs have to certify their company's financial statements by signing their names.  If their numbers are wrong, they can go to jail.  So, some CEOs may insist that their CFOs "haircut" the numbers the accountants give them to make the books look worse.  They may no longer care if the share price goes down as a result.

Call me cynical, but I have to question the wisdom of putting a large federal review board in place to oversee corporate accounting.  After all, the terms "federal government" and "honest accounting" are OXYMORONS!

FYI, it's not as if we don't have a government agency overseeing accounting firms.  Currently, CPA firms that audit public companies are required to have an independent "peer review" at least once every three years.  These reviews are then also reviewed by a federal agency called the Public Oversight Board (POB). 

Just this week I learned that the top five accounting firms are exempt from POB review.  Isn't that special!  Will they also be exempt from review by the new accounting board?  Let's hope not.

I have not seen the actual corporate reform bill yet, but our CPAs told me something very surprising this week.  The bill stipulates that a majority of the five members of the new federal accounting oversight board must be "non-accounting" types.  What kind of sense  does that make?  So, the two members who actually understand accounting can be out-voted by the three who don't understand accounting!

As I said earlier, there are some good things about the new corporate reform bill, but there are also some bad things.  And there are some that say it's too early to tell whether they will be good or bad. 

When I saw the Senate  vote 99-0 in favor, and the House vote was 423-3, with one of the NO votes being Ron Paul, I thought to myself, this is not good!  Virtually everyone, including the President, wanted their name on this thing.

I am the first to agree that something must be done to clean up corporate accounting in public companies.  But I don't know if enlarging the SEC is the answer.  After all, it wasn't the SEC who nailed Enron, Global Crossing or WorldCom.  It was largely because of whistleblowers on the inside.

I hope the new federal accounting oversight board works but, frankly, I have my doubts.  Seems like the markets have their doubts, too!

What About Stock Options?

As the corporate reform bill weaved its way through Congress, it included new restrictions on employee stock options and the accounting for same.  But somehow at the last minute, the stock options restrictions were withdrawn from the bill.  Hmmm.

Stock options are a valuable and powerful incentive to management and employees since, in theory, they should align management's best interests with that of the shareholders.  With part of management's compensation in the form of options, they should have an incentive to make sure things continue to go well so the stock price will remain strong and move higher.

Typically, options are awarded to management for improved company performance (i.e. - profits).  Typically, the options include a required holding period before the employee becomes "vested" and can  convert the options to shares of stock and then sell on the open market, if so desired.  For many years, the typical holding period before selling was four years.  In recent years, however, many companies have shortened the holding period dramatically.

As most of us know, options can be abused, and certainly have been in recent years.  Corporate managers have demanded, and their boards have approved, unheard of amounts of stock options.  Options increase the float of shares outstanding, thereby diluting earnings per share of the stock.  This is a big reason why P/E ratios got so astronomical in recent years.  But when the markets were rising rapidly as they did in the late '90s, investors didn't seem to care that CEOs and other top management were receiving unprecedented amounts of stock options.

Making matters worse, most companies do not count stock option compensation as an expense.  In many companies, stock options don't even show up in their financial statements.  A few years ago, legendary investor Warren Buffet warned about options abuse:

"If options are not a form of compensation, what are they? If compensation isn't an expense, what is it? And, if expenses shouldn't go into the calculation of earnings, where should they go?"

Under Generally Accepted Account Practices (GAAP), options can be granted by companies without being included as a salary expense on the balance sheet.  Simply speaking, the company can pay its employees millions of dollars with zero effect on the bottom line.  This means that management can pay themselves enormous comp packages,weighed heavily in options, without impacting the bottom line of the company.

The cost comes in the form of share dilution, affecting the shareholders by lowering earnings per share.  Companies get to compensate employees in a way that allows them to ignore the cost on their balance sheet.  This would seem to be a simple choice for management: pay themselves in cash and count it as an expense, or pay themselves in options and ignore the cost on their balance sheets.

Zero Risk

Another area of abuse is what is called "repricing," which is truly a heads-they-win, tails-we-lose proposition.  If the price of the shares falls, many companies simply reprice the options held by management to a level that is below the current, lower price of the stock.  This would be similar to you getting a rebate at company expense on your stock because it went down after you bought it.  This, of course, is absurd!

Equity investments are not insured, and we all take the risk that the price might go down whenever we invest in stocks.  Yet management can remove the risk for themselves by repricing their options to lower levels if the market goes down.  This is a direct expense to the shareholders.  If only we had the same tool to write off losses!

I could write pages about stock options and the potential for abuse.  You would be surprised to learn how much of the outstanding stock of many companies is represented by options held by management.  But in summary, most companies do not treat stock option compensation as an expense.  And, many companies allow management to reprice their options if the share price falls.

The new corporate reform bill included no provisions to correct the rampant abuse of stock options.  I wonder why?

As noted earlier, Rep. Ron Paul of Texas was one of only three congressmen to vote against the corporate  reform bill.  As of this writing, he has not posted his reasons for voting no, but I'll bet the fact that options abuse was not addressed is one of them.  Until this is addressed, we should all assume that it will continue.

*      *      *      *

Most Of Us Need Professional Help . . . . How Our Programs Fared  

Investors In Shock

Millions of Americans were in shock as the markets crashed over the last two months.  Many, I suspect, have not sat down and figured out how much they lost or how it will affect their retirement plans.  Most analysts agree that the markets will not average anything like the returns we saw in the late 1990s in the future.  Most are predicting a return to the historical averages in the 8-10% range.  If so, it will take years for buy-and-hold investors to recover their losses.

The recent market meltdown speaks volumes about the need for professional management.  Most investors don't know when to get out, or if they do, it's often at the bottom.  This is why I have emphasized market timing for so long.  I have never suggested that investors put all their money in market timing strategies, but for the last year, I have argued that people should increase their allocations to market timing advisors who can get out of the markets if need be.

So How Did Our Equity Programs Do?

For the last year, we have been directing our clients to three market timing programs in equities.  Here's how they have done this year as of the end of July:

Niemann Risk Managed                        -2.5%

Potomac Conservative Growth             -2.8%

Hallman & McQuinn                               -4.6%

S&P 500 INDEX                                     -20.6%

NASDAQ INDEX                                     -39.0%

I'm sure there will be some who don't view these numbers as impressive.  But I certainly do!  And I think most of our clients who are in these programs view them as impressive as well.  I continue to recommend these programs, especially in light of the very volatile and uncertain market conditions we face.

Our Futures Funds Did Very Well

The Diversified Fund and the Alternative Asset Fund turned red-hot in June and July.  The Diversified Fund gained 10.3% in June and 6.8% in July.  The Alternative Fund gained 11.5% in June and 8.2% in July.  They served their purpose of diversification very well over the last two months.  Our Long/Short Growth Fund is up 8.8% this year as well.  (Past performance is not necessarily indicative of future results.)

Unfortunately, none of these funds are open to new investment.  We do have a privately offered futures fund that has also done very well this year.  It is available to accredited investors only.  Call us if you would like more information.

A New Bond Timing Program

As noted on page 1, for several years, we have searched for a good bond timing program to recommend to clients.  Well, we've finally found one.  Capital Growth Management, Inc. in Pennsylvania has an outstanding 10-year track record in timing carefully selected high-yield bond mutual funds.  In addition to their original program, CGM also has a leveraged version with even more impressive returns.

We introduce you to CGM in the enclosed issue of Professional Investing.  CGM is one of the steadiest performing Advisors I've ever seen, with very low drawdowns.  As a result, and with the equity markets in such disarray, I highly encourage you to read my article on CGM and consider putting some money with them.  I'm putting a chunk of my own money there.  The minimum investment is only $25,000.

Read the article in Professional Investing and then request more specific information and applications.  Call us toll free  at 1-800-348-3601 or Contact Us.