And you thought Wall Street gives bad advice….

Jesse Bogdonoff was an American businessman working in the South Pacific Kingdom of Tonga. Bogdonoff was a clever guy with a good sense of humor who caught the fancy of Tonga’s King Taufa’ahau Tupou IV who appointed Bogdonoff the official Tongan court jester. Years earlier the Kingdom, which is dirt poor, had made, by their standards, a significant amount of money selling Tongan citizenship to Asians such as former Filipino president and first lady, Ferdinand and Imelda Marcos. The funds that totaled about $25 million represented approximately 40% of the annual Tongan budget.

Bogdonoff convinced the King to allow him to manage the Tongan reserves and had the funds transferred from a checking account to Millennium Asset Management Company, which Bogdonoff may have owned. Some money was invested in Trinity Flywheel Power that Bogdonoff did own and a small dot.com company. Unsurprisingly, the investments came a cropper and Tonga is now suing Bogdonoff who denies "deliberate malpractice." We are not sure whether he is still the official court jester. While the above might seem amusing, what’s going on in politics, the economy, and the financial markets is no laughing matter.

George W. Bush continues to enjoy sky-high popularity ratings. His focus on the War on Terrorism and emphasis on national defense along with his high level of personal integrity has, to date, overridden the sluggish economy, growing Federal budget deficit, awful stock market, and burgeoning business and accounting scandals. The Bush administration seems to be willing to trade political favors to achieve its (laudable) defense goals. But growing non-defense spending and previously passed tax cuts along with economic weakness are causing the federal budget deficit to balloon. While counter-cyclical fiscal moves such as spending increases and tax cuts are traditionally the Keynsian prescription for economic problems, Democrats are increasingly willing to make political hay out of these stimulative policies. Additionally, compromises on protectionist legislation, such as steel import restrictions, and outsized increases in farm subsidies have caused conservatives to question Bush’s rightist credentials. The above will be issues in the mid-term elections.

The recent spate of corporate accounting scandals will likely be another key issue during the upcoming mid-term elections. Montgomery Brothers wants to inform you of accounting irregularities we’ve discovered at a major organization right here in Washington, DC. This entity refuses to adopt accrual accounting and chooses not to comply with Generally Accepted Accounting Principles (GAAP). It reports "seasonally adjusted" results which are restated three times a quarter, and then again years after the fact. It regularly borrows from its employees’ retirement plan and refuses to adequately account for those future liabilities. Its guidelines for growth and operating surpluses are routinely wildly off the mark. If you haven’t guessed, we’re talking about the Federal Government. It should be interesting to watch politicians bash American business, while continuing to mine the rich vein of corporate political contributions without running afoul of the recently passed campaign finance reform legislation.

Republicans are likely to lose seats in the House and Senate in November, possibly making for even greater political gridlock. From a longer-term political point of view, American voters drifted to the right during the long economic expansions and bull markets of the 1980s and 1990s. Now that times are tougher and people feel duped, anguished cries for help are mounting. A political drift to the left is possible, probably likely. A larger, more expensive, and increasingly intrusive federal government (like those in Japan and Europe) would not be good for the economy or financial markets.

In spite of the briefest, most shallow "recession" on record and two consecutive quarters of growth (including 6+% during the first quarter), it feels like the economic wolf is at the door. Talk of a double-dip recession or of a long period of economic stagnation abounds and the chorus of naysayers is growing. Economists, as well as normal people, have a tendency to straight-line the recent past into the immediate future. Much like the good times of the 1990s were extrapolated into a "new era," the current tough times are now expected to continue for the foreseeable future. While the possibilities of further terrorist actions are real, the probabilities of political blunders seem more likely to us. But the U.S. economy is remarkably resilient. That old reliable workhorse, the American consumer, has continued to pull the economic wagon. Home building and auto sales, usually early casualties of economic downturns, have been very strong. Interest rates, which we expect to stay low, make the outlook for home and vehicle sales pretty decent. Income continues to grow and confidence, all things considered, is high.

Many have written off the corporate sector as a possible engine for economic growth and the current technology and telecommunications capital spending bust apparently justifies this belief. However, orders have been improving and industrial production rising while inventories are at historically low levels. The Fed appears willing to tolerate somewhat higher inflation in order to provide corporations with a little pricing power. Such pricing power could lead to higher corporate profits, which might, in turn, lead to additional capital spending. We’ll see. But to underestimate the corporate sector is to deny much of the economic success of the past two decades, if not two centuries.

Shown below are six charts showing various key economic indicators.

All look fairly promising. Additionally, federal fiscal policy is expansionary and a growing trade deficit is (ironically) more indicative of domestic and global economic expansion than contraction. If Montgomery Brothers made official economic projections, we’d be increasing our forecast for growth.

Monetary policy remains stimulative with interest rates near 40-year lows and the monetary aggregates expanding rapidly. The Fed recently decided to leave monetary policy alone and hinted that current policy was unlikely to change soon. Unfortunately, the Fed also continues to question the strength and durability of the nascent recovery. Montgomery Brothers is not suggesting that the Federal Reserve Board be replaced by the Dallas Cowboys Cheerleaders, but the Fed could present a more positive outlook. And aren’t we all a little tired of Alan Greenspan’s schoolmarmish negativism? A little "can-do" optimism would help.

Our concerns over the Fed’s possible willingness to tolerate slightly higher inflation are reflected in the currency and gold markets. Let’s go to the charts:

Maybe the rise in the dollar price of gold and the Yen/Euro price of the dollar reflect a previously depressed gold price and overvalued dollar. Much as the stock market wildly overshot its justifiable valuations during the Bubble; gold and the dollar may have reached unjustifiable levels, as well. The resultant price reversals of stocks, gold, and the dollar might be part of normal albeit not pleasant "corrections." Again, we’ll see.

Nevertheless, the Fed is likely to continue to steer monetary policy on its currently neutral but still expansionary path. The recent bond market rally has been almost exclusively a "flight to quality," benefiting primarily U.S. Treasury and agency bonds. The negative budgetary situation of state and municipal governments and the seemingly never-ending corporate scandals have put a price lid on municipal and corporate bonds. Montgomery Brothers views this more as an opportunity to swap Treasuries into municipal and corporate bonds. Unfortunately, not without assuming greater risk in the process.

Where is Gordon Gekko when we need him? Probably where so many recently fallen corporate executives deserve to be and probably will end up: in jail. Many are asking how corporate executives could have gone so far off track? What happened to their ethics, morals, and judgement? Unfortunately, corporate shenanigans and malfeasance expand with economic growth and bull markets. Every Bubble from the Tulip Bulb craze on has been followed by revelations of fraud and wrongdoing. And generally the bigger the Bubble, the greater the following bust. As long as extraordinary gains are accruing to most, the warnings of the few go unheeded. During this most recent Bubble, incentives, especially stock options, tied corporate compensation to stock prices in an unprecedented and, in retrospect, excessive manner. Also, during this period, the United States was led by a morally challenged president with a myriad of ethical problems. His indiscretions and possible perjuries were largely shrugged off by the majority. Leadership starts at the top. However, when the Bubble burst and people started to lose money, few were willing to look the other way. Legal actions, new legislation, and regulatory reform are inevitable. Even though adequate rules and regulations exist which prohibit everything recently experienced, expect more!

Fortunately, and contrary to popular belief, not all businessmen are crooks, not all accountants are cooking the books, and not all politicians are on the take. Unfortunately, the stock market is pricing itself as if they all were. Opportunity knocks but only gently. Stocks aren’t cheap but with interest rates likely to stay low for the foreseeable future, valuations are not unreasonable. Corporate profits will not boom as the analysts are forecasting, but who listens to those jokers anymore, anyway? Besides, nobody actually knows what "profits" even mean right now. Stock investors have, like jilted lovers, turned hostile toward stocks. The mood on Wall Street is dour.

Montgomery Brothers is forecasting a much better equity investing climate over the next six to twelve months than we’ve experienced over the past two years, and certainly last quarter. Shown below is a chart of the major market averages since the approximate market top at the end of the first quarter, 2000.

INDU is the Dow Jones Industrial Average, RUTZ is the Russell 2000 Index, SPX is the S&P 500 Index, WILXI is the Wilshire 5000 Index, and COMPQ is the NASDAQ 100 Index.

The current bear market is now longer than any since the late 1930s/early 1940s, and has declined more than any since 1973-1974. While some stocks have done OK, most have not. The unweighted decline in the average S&P stock is 8.2% over the past year while the S&P 500 average is down by 19.2%. More telling, however, is the list of widely owned stocks whose prices have declined sharply over the past 12 months. For instance: AOL Time Warner is down 72%, EMC is off 74%, Lucent is down 67%, IBM off by 40%, and Worldcom is down 99%. The list goes on and on. Sure, long U.S. Treasuries, gold, REITs, and small cap stocks have done well but no one owned enough of those to offset what they did own. Wall Street is now advising investors to buy bonds, gold, REITs, and small caps. Exactly what has been working. Too bad so few were recommending that these be bought two and a half years ago. Not that anybody would have listened. Good Lord! Wall Street analysts are even issuing SELL recommendations. Two years into a Bear market, wouldn’t you know.

We don’t believe that we’re off to the races again, but we do believe that we’re long overdue for a significant rally of some lasting duration. The "average" equity investor has switched from "buy every dip" to "sell every rally." Therefore, upward progress will be difficult but not impossible. If the stock market is supposed to "climb a wall of worry," it’s right there in front of us for all to see.

Maybe it’s because so many are bearish or maybe it’s just because we are sick and tired of being bears, but Montgomery Brothers is officially turning bullish. Not foaming-at-the-mouth, throw-caution-to-the-wind bullish, but constructive on the outlook and cautiously optimistic that good things can happen too. Some might say "Surely you’re joking." But we’re not joking, and don’t call us Shirley!
 
 

July 1, 2002                 John E. Montgomery
 
 

Some charts courtesy of www.briefing.com, and Baseline.