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There is an old Wall Street adage that claims that no one rings a bell at the beginning of a bull market. In our second quarter outlook, we outlined our rationale for why we felt a more aggressive investment stance was warranted. The first five weeks of the second quarter made us look like true market savants. From mid-March until the first week in May the stock market put together the longest stretch of weekly gains in nearly a decade. But just as quickly, the market gave it all back and more. Interest rates continue to be the major impediment to both economic recovery and a sustainable upmove in the stock market. In this Second Half 1982 Outlook, we outline why we continue to feel strongly that investors should be fully invested. In reviewing the Second Quarter 1982 Outlook we feel that two alternative quotes could have been used rather than "It's Always Warmest In the Middle Of the Crowd." One could have been "Fools Rush In Where Wise Men Fear To Tread" or more appropriately "The Early Bird Catches the Worm."

The economy is giving off an increasing number of signals that the worst is over. The recent "Flash Report" from the Commerce Department forecasts that 2Q'82 GNP should expand 0.6% at a real annual rate. This would be quite an improvement over the 1st quarter's 3.7% decline. Recently positive economic news has outweighed negative news leading many economists to jump on "the economy has bottomed" bandwagon. May's 0.3% increase in the leading economic indicators was the third monthly increase in a row which usually is the minimum which economists took for to justify a trend. Economic bears can point to the continued decline in the ratio of coincident to lagging indicators as a sign of a future weakness since it implies that the costs of conducting business is rising even while business weakens. Even though industrial production declined 0.2% in May for the ninth time in the past ten months (the only exception was February when industrial production snapped back after the horrendous January weather) the decline was the smallest since August of 1981 and may have marked the end of the decline in economic output. So far in the current recession production has declined 8.8% from the economic peak in July of 1981 compared to an 8.3% decline during the 1980 downturn and slightly greater than half the 15.3% drop during the 1973-1975 recession.

Consumers seem to be coming out of their long hibernation. Retail sales led by autos, general merchandise and clothing increased by 1.5% in May and have shown improvement in three of the past four months. Consumer credit expanded at an accelerating rate in April and the increase was the largest since September of 1981. Personal income in both current and constant dollars continues to increase and both stand at record levels. In May personal income increased 0.7% while personal consumption expenditures rose 1.3% implying that savings rates declined to approximately 5.2% We feel that the consumer has started to spend the July 1st tax reduction but believe both savings and spending will show improvement. (While many, including ourselves, have made a "big deal" out of the tax reduction and increases in social security transfers it is important to note that these income increases will occur over the next twelve months and will not give the economy a quick fix). Auto sales have shown improvement over the quarter and General Motors has reinstituted the 12.8% financing package which should aid sales, Nevertheless, we doubt domestic auto sales will exceed 7-8 million units annually. Housing starts were up 22% in May and above the one million mark (annually), for the first time in ten months. Mortgage rates continue to be a larger impediment than prices at this point and we are skeptical that starts are likely to surpass 1-1.2 million annually even with an economic expansion.

While consumer confidence is improving, it is still quite low. With unemployment likely to expand slightly in months to come (remembering that unemployment lags economic activity) a consumer spending boom is unlikely. However, the 100.1 million people who are employed (which is less than 1% below the all-time record) are likely to prudently expand their spending and savings as their real disposable incomes expand. Since consumer spending represents approximately 65% of total GNP we feel this factor alone can increase GNP by roughly 2% per annum in real terms.

The outlook for corporate spending is considerably less promising. With interest rates still prohibitively high, factory utilization rates at levels comparable to the bottom of the 1973-1975 recession and unemployment nearing 10,70, there seems little reason for capital spending to advance. Most recent surveys show that real capital expenditures are likely to decrease by 2.5% in 1982. Since many capital expenditure programs were started with high inflation assumptions we feel that retrenchment is more likely than expansion. Additionally, revisions in 1Q'82 inventory figures show that liquidations were not as widespread as previously believed and that inventory/sales levels are higher than desired. Corporations remain in a highly illiquid position. As the economy and cash flows improve, companies are far more likely to repay borrowings and improve balance sheets than embark on new spending projects. This should reduce corporate demands for credit and could help take pressure off interest rates.

And interest rates continue to hold the economy in a vise. Even though the Federal Reserve System has been quite accommodative recently by allowing Ml, M2 and Reserves to expand at well above target levels the insatiable demand for borrowing has continued. Since this time last year, short term interest rates are down approximately 220-230 basis points while long term rates are up approximately 140-150 basis points. Since the beginning of 1982, rates have been on a roller coaster ride and are back to where they started in early January. The yield curve is generally back to a positive slope which is at least the minimum necessary for the corporate reliquification process to occur.

Much has been said about the high real rate of interest, i.e., adjusted for inflation. It took approximately ten years for the investment community to grasp the significance and intractability of inflation on the economy. A year of inflation abatement had not been sufficient to reduce the huge inflation premium currently built into bonds. Investors look at interest rates and feel that inflation must still be a real worry and demand high risk premiums. Individual investors, especially those who have historically saved via passbooks, are delighted by these high real returns. And how high are real rates? Assume a fifty percent tax bracket saver and a 7% core rate of inflation. The saver puts his/her money into a one-year treasury yielding 12.2%. After subtracting out the 7% inflation rate and being taxed 50% on the interest, his/her real return is approximately 3%, which is certainly not stratospherically high. We, nonetheless, continue to feel that interest rates can decline by 200-300 basis points for short rates and 150-200 basis points for long rates by year end. Near term volatility will continue due to fears of the need for the Fed to tighten its grip on the money and credit supply and the tremendous near term demand for borrowing by the Federal Government to fund deficit spending.

The administration continues to be perplexed by the high levels of interest rates in the face of the success in bringing down inflation. The 1% increase in May's consumer price index was every bit as much of a fluke as the 0.3% decrease in March. Energy price weaknesses due to the "glut" had caused inflation numbers to be understated earlier in 1982 and are now overstating inflation. Inflationary pressures have not and will not abate quickly and a brief return to double digits could strengthen political backbones in this long-term battle.

Inflation is a political beast caused primarily by the government living beyond its means and creating the money to do so. A "fiscally responsible" budget deficit of "only" $103.9 billion is a charade foisted upon the American public by self-serving politicians trying to get reelected. Usually as the economy enters a recessionary period our elected officials fall all over themselves trying to cut taxes and raise spending in traditional Keynesian counter-cyclical fashion. When the economy finally enters a downturn with such a program in place, the same politicians are falling all over themselves trying to undo what they historically have tried to do. Is it any wonder that the population, in general, and the financial markets, in particular, have viewed the congressional budgetary pas de deux with a high degree of skepticism? Those that have based their decisions on the assumption that politicians would follow the politically expedient (and usually inflationary) path have been consistently correct. It took the American public and the financial markets fifteen years to figure out the inflationary implications of government policy. It is unlikely that this inflationary psychology will quickly evaporate. It is equally unlikely that interest rates will decline significantly as long as the political reality mirrors these inflationary expectations. Hopefully after the November elections are over and before the 1984 campaigns begin our elected officials will rationally address the fundamental issues.

Regardless of the political situation, the economy seems ready to embark on a subnormal recovery. With disposable incomes increasing, a tax cut in place on July 1st, balance sheets in decent shape and attitudes generally improved, the consumer is likely to increase both spending and savings which would fuel economic growth and increase the supply of lendable funds possibly reducing interest rates. While not expecting capital spending to expand, we believe that corporations in general have worked inventories down to acceptable levels especially if the gradual improvement consumer spending continues. Defense spending is starting in earnest and corporate cash flows are benefiting from accelerated depreciation. The federal government is running a highly stimulative fiscal policy (and if $ 100 billion+ budget deficits are not stimulative, what is?) Lastly, the Federal Reserve has been increasing the money supply and non-borrowed reserves at levels which will allow nominal GNP to grow faster than inflation which should result in real growth of 2-4% for the next several quarters. While there is the possibility that interest rates would abort this fragile recovery, we believe the probability is less than the majority feels. Besides high interest rates should act as a curb to fiscal and monetary excesses which got us into this box in the first place.

Since the 1Q'81, the economy has declined by approximately 2.3% which is slightly greater than average for post WWII recessions. Corporate after-tax profits, however, have declined by approximately 40% which is well above recessionary averages. Due to extremely deflationary cyclical pressure, this decline in constant dollar, after-tax profits has been quite uneven among industries. Durable goods manufacturers such as autos, primary metals, base chemicals, housing and forest products have seen profits deteriorate to almost zero, while retail, wholesale, utility, communications and service sectors have shown little or no decline. We feel that this earnings slide has come to an end and that corporate profits are likely to improve at a pace well above economic growth for the next several quarters. The slowdown in unit labor costs and raw materials should have a beneficial impact on costs. The slight speedup in inflation could allow selected price increases, which would have a beneficial effect on operating margins. The decline in capital spending should allow corporations to dedicate improving cash flows to debt repayment, thereby lowering interest charges even if interest rates remain high.

After the past six recession troughs, the average four-quarter advance in real GNP has been roughly 6%. Constant dollar after-tax profits have, on average, increased 15.4% four quarters after their troughs. In general, the greater the preceding decline in profits, the greater the profits rebound. This is especially significant since the level of after-tax current dollar corporate profit never even got close to surpassing its pre- 1980 recession high. We feel that corporate after-tax profits should be able to expand at a 20-30% annual rate over the next several quarters barring congress increasing corporate tax rates to help balance the budget. (A recent cartoon that I saw put corporate taxation in a perfect framework. It has a gentleman quaffing lemonade at a child's neighborhood stand. The sign on the child's stand read "Lemonade $2.00 A Glass," and the man is remarking to the child that he would certainly hate to pay the child's corporate taxes). We feel that, contrary to popular belief, surprises are likely to be on the upside rather than the downside as far as both economic growth and profits are concerned.

If you think it's getting old hearing that "stocks are cheap" you should spend about six months trying to convince people of the fact. (I recently ran into a broker who was celebrating(?) her sixteenth year in the business and she remarked that the Dow Jones was lower on that day than it was on the day she became registered with the New York Stock Exchange.) Below is the comparison data for the movement of several market indices for the second quarter and first half of 1982:

Salomon Brothers recently completed its annual investment survey which compares 14 investment categories to the consumer price index. The survey ran from May 30, 1981 to June 1, 1982 and did not include cash equivalent investments. It showed that bonds were the only category which outpaced inflation during that period. However, over the past ten years the returns on bonds finished last in the survey and had negative returns when compared to the CPI. With nominal interest rates in middle double digits and inflation at 7-9% and declining, the attraction of bonds seems obvious. As discussed earlier, real returns, especially for individuals, are considerably less than nominal rates indicate. While we continue to feel that total potential nominal returns for equities and fixed income securities are approximately equal, the favorable long term capital gains treatment on the appreciation component of equity returns should lead all but the most risk averse and income oriented individuals to overweigh the equities component of their portfolios. For tax free institutional investors, the reinvestment rate on superior current returns from bonds should make total returns equally attractive between stocks and bonds.

In the equities markets it has long been assumed that stock prices anticipate improvements in the economy, and in after-tax profits hence the inclusion of stock prices in the leading economic indicators. If we are correct that 2Q'82 marked the trough in current recession and that corporate after-tax profits are likely to improve over the next several quarters, stock prices should be moving ahead. The tremendous pessimism and skepticism in the financial markets is widely documented and largely justified. The "depression is near," "interest rates will surge back to record levels," "political irresponsibility" fears and other doom-and-gloom forecasts are certainly understandable and admittedly can be logically argued. We continue to feel that the end of western civilization is not imminent and somehow the economy will muddle through. The equities markets in their usual pendulum swings from euphoria to deep seeded gloom seems to be reflecting the possibility (maybe even the probability) of disaster. But how bad is the economy when Chrysler, International Harvester and Pan Am have been able to stay in business and when over 75% of the one million new entrants into the job market in May were able to find employment?

The technical side of the market seems to be as confusing as the fundamental with mixed signals being given. Even though we are fundamentalists at heart it is important to follow what the technical indicators appear to be saying if for no other reason than that so many people do put such heavy emphasis on technical analysis. The four basic groupings of technical indicators which we follow are price and volume, monetary, liquidity and sentiment. In the price and volume area, the market has retested its lows for the third time since September, 1981. Granted, the majority of the major averages broke to new lows but there were positive divergencies for the utility and bond averages as well as the NYSE advance/decline volume data. New lows were fewer in June than in March ('82) and September ('81) and the momentum indices became considerably oversold. While these indicators are less than wildly bullish, one can argue a solid case of base building. the monetary indicators are equivalent to the levels preceding the March/April rally although less bullish than in September. While the Federal Reserve actions have given positive signs, interest rates movements have been negative due to inflationary fears resulting from expansive monetary policy. These indicators are at best neutral. There are bullish readings in the majority of liquidity indicators with margin debt expanding in May for the first time in several quarters, high levels of institutional cash, near record short sale levels and surging money market fund deposits. The sentiment indicators are on balance the most bullish of the four with only odd lot short selling failing to give good readings. Specialists and member short selling is at low levels, investment advisors are squarely on the bearish side, option players are very bearish and secondary stock offerings are quite low. On balance, while the all-clear signal cannot be given technically the positives seemingly outweigh the negatives.

So far in 1982, the major problem in having bought stocks when they were cheap is that they generally have become cheaper immediately. The July 5, 1982 Business Week has an article in its personal business supplement entitled "What To Do When Investments Sour." In the article, Ronald Koenig, managing director of Ladenberg, Thalman, advises, "If you believe that you own stocks of companies with solid fundamentals, put the blinders on for a while and don't think about the short term." While we do not wish to sound like we are advising an ostrich investment policy, we do agree. Few things are worse than buying good companies when they are cheap, watching them become cheaper, selling at the bottom, then watching them go up while you sit in cash. At worst, we are expecting a good short to intermediate term rally to develop which we believe could complete the base building period which would end this rapidly aging bear.

Does the early bird catch the worm or do fools rush in? Ding Dong Ding.

John E. Montgomery

July 1, 1982 Director of Research