Equity investors thought that they had hit the trifecta last week. The Republicans virtually swept the elections, the Fed cut the discount rate 50 basis points and Harvey Pitt resigned from the SEC. All in 24 hours! But after a five week run to the upside and a weak rally on the Wednesday after the election, the stock market headed South. Go figure!

The political pundits were again reminded of how weather forecasters and stock market pundits regularly feel: dumb and wrong. Even Bush’s supporters underestimated him and now Dubya is nearly universally credited with administering the Republican butt-thumping of the Democrats. Granted, the Democrats really presented no alternative to the Republicans. Having spent two years playing "just say no" politics with Bush, the Democrats tried to run almost exclusively on a "we’re not Republicans" platform. Disastrously.

Republicans immediately claimed a mandate even though a more sober analysis would indicate a still fairly evenly divided electorate. Many cheer while others fear the possible right-wing political blitzkrieg. Judicial nominees are likelier to be approved and Bush legislation is likelier to see the light of day. But sweeping change is unlikely.

What is likely is some pro-investor legislation. With nearly 50% of the electorate currently shareholders, Democrats can no longer dismiss proposals such as capital gains tax reductions as "giveaways to the rich." At a small luncheon which I attended, Treasury Secretary Paul O’Neil spoke of grand plans for tax reform, but in the Q&A much less was seen as likely to happen. Montgomery Brothers expects some action to reduce the double taxation of dividends and an increase in the amount of stock losses deductible from income, which will be helpful but certainly no panacea.

Montgomery Brothers does believe that President Bush will pursue his policies very aggressively. Many thought that Bush’s Iraq stance was a "Wag the Dog" policy to keep the electorate’s focus off the economy. But in his first press conference after the election, Bush reiterated Homeland Security and Iraq before he mentioned economic stimulus or tax reform. His tenacity on Iraq and terrorism has paid political dividends. We believe that such tenacity is likely to be increasingly applied to his economic initiatives. Presidential elections are almost always decided on pocketbook issues so Bush will be far more interested in how the economy will be doing in 2004 than in how it was doing in 2002. With monetary policy looking pretty impotent right now, look for Bush to be viagra-izing fiscal policy, pronto! Most have underestimated George Bush. But, so far, most of the surprises have been to Dubya’s upside.

The third quarter was the fourth straight quarter of economic expansion. 3Q ‘02 GDP growth was reported at an annual rate of 3.1% with inflation only 1.4%. Virtually every country in the world is envious of such economic performance, yet the domestic whining and kvetching is deafening. "Sub-par" and "jobless" are the adjectives most frequently used to describe the current economy. But - come on - while the recovery has been sub-par, the preceding recession was also and it came on the heels of the longest economic expansion on record. The unemployment rate, which lags the economic cycle, has yet to go over 6% during the past recession and its "sub-par" recovery. 6% used to be considered a floor and, if the unemployment rate went below 6%, inflation was sure to follow. Now worries are about deflation. Additionally, the highly touted and desirable "productivity" ironically hurts employment. If the economy is growing at 3% and productivity is expanding at 5%, there is little incentive to hire additional workers.

The previous recession was primarily a garden-variety inventory correction greatly exacerbated by a dramatic decline in capital spending following the capital spending binge of the 1990s. The consumer has continued to spend right through both the past recession and its current recovery. Concerns are high that the consumer is overleveraged and tapped out. We’ve been hearing this for over two decades and yet the consumer always comes through. With over 130 million employed and incomes growing at around 3% annually, MBI is skeptical that consumers are going on a spending strike. The economic consensus expects that consumer spending during the current quarter will be the weakest since 1993, forgetting that 1993 was early on in what ended up being the longest expansion in U.S. economic history.

The hope is that the corporate sector will pick up capital spending. The Fed has reduced interest rates dramatically and there will be additional tax incentives in an effort to spur corporate investment. But with capacity utilization well under 80% and corporate risk takers about as popular as skunks at a garden party, MBI ain’t looking for the business sector to ride to the rescue. Having run a fiscal surplus for the last few years of the expansion, shouldn’t the U.S. be running a deficit if we are truly worried about the economy? Keynsian economics says that’s what should be done and it used to be automatic that deficit spending was used in difficult economic times. But now many Democrats are beginning to sound like Herbert Hoover in the early 1930s. What is really needed is a period of political patience, but that’s unlikely. The recent election should put sharp lines under the fiscal policy debate. The Republicans will want to cut taxes and let taxpayers decide how to spend such fiscal stimulus. Democrats will want to increase spending for their pet projects.

We expect the budget deficit to grow but really not to be of great help to the economy. Lastly, most foreign economies are in worse shape than the U.S. and are looking to us for help. All in all, Montgomery Brothers is expecting more of the same. Slow growth, low inflation, and high anxiety.

The nicest thing that we can say about the latest Federal Reserve cut in the discount rate from 1.25% to 0.75% is that while it probably won’t help the economy, in all likelihood it won’t hurt the economy either. We’re not sure what the Fed is up to, but after saying for years that there are long lag times for changes in monetary policy to affect the economy, this most recent cut was aimed at getting the economy over its current "soft spot." At the same time that the Fed has been slashing short-term rates, the Comptroller of the Currency continues its regulatory reign of terror on bank lending. Therefore, the declines in interest rates aren’t always getting to the intended corporate beneficiaries in anywhere near the degree that they have benefited the federal government’s finances and mortgage borrowers. Meanwhile, corporate borrowing continues to decline and the lending environment remains hostile to all but the more credit-worthy borrowers. It appears to us that corporate executives are more interested in shoring up their balance sheets by paying down debt than they are in making capital expenditures especially since corporations have plenty of capacity.

Meanwhile, the yield curve has steepened, again, and credit spreads remain wide. A steeper yield curve (see chart below) is generally indicative of faster economic growth and/or higher inflation ahead.

The steepening of the yield curve in mid-2001 did forecast the current recovery. But the steepness of the yield curve back then also forecasted rapid economic growth and/or higher inflation and neither has happened. Credit spreads usually widen going into periods of recession or slowing economic growth and narrow as the economy expands. So we have conflicting messages from the debt markets. Does this mean that "This time it’s different?" Investors have been selling risk and buying safety. As Will Rogers once said "I’m more interested in the return of my capital than the return on my capital."

Montgomery Brothers believes that the Fed is trying to force investors to lengthen the duration of their investments - i.e. sell money markets and buy longer maturity bonds and/or stocks. With money market rates likely to dip below 1.0% soon, investors would certainly like better returns, but since the beginning of 2001 when money market rates were nearly 6%, investors have stuffed over $375 billion into money market funds that are now yielding around 1.25%. To a limited extent money has been flowing out of stock funds and into bond funds. Returns on bonds, in general, have outdistanced the return on stocks, in general, for the past one, three, and five years. Wall Street is currently recommending bonds. Is it time to get bearish on bonds?

In all of our years in D.C., we don’t think we have ever encountered anyone as politically tone-deaf as Harvey Pitt. While virtually everyone is glad to see him go, the glee could be short-lived. The SEC chairman’s main job is now that of chief-improver-of-investor-confidence. Additionally, he (she) will have to be the Grand Inquisitor of Wall Street and the Preventor of Corporate Fraud. One would think that conflicts of interest on Wall Street and corporate wrongdoing were relatively new phenomena. Given the scope of "the Bubble," we’re actually surprised that there wasn’t more. Montgomery Brothers will be interested to see who is willing to step into the SEC chairmanship next, but we fear that it will have to be a zealot. We might prefer to cast our lot with crooked corporate executives rather than well-meaning politicians. At least we know what to expect from crooked execs. Given the law of unintended consequences, we never know what to expect from the politicians.

There’s nothing like a good old-fashioned rally to make investors feel better. Following the 18% decline in the S&P 500 during the third quarter, the 9% increase during October (14% from the low on 10/9) was a great relief. Unfortunately, bullishness has increased dramatically and everyone wants to know if we've "seen the bottom." Shown below is a chart of the weekly price changes in the S&P 500 from the end of 1Q ’00 through last Friday, along with 200- and 50-day moving averages.

As you can see, we’ve experienced a number of spirited rallies since the current bear market began, all of which have, to date, failed.

Whether this is just another "get shorty" rally or the start of something bigger only time will tell. Stocks are not cheap but they are generally more reasonably priced than they’ve been in years. The P/E on the S&P 500 has declined from a high of 30.4 to 20.2 today. With the yield on the ten-year U.S. Treasury at 3.9% the P/E on the S&P should be around 25.6 according to the Fed’s internal model. Unfortunately, the "E"(Earnings) in P/E are now suspect, and the outlook for corporate profits remains cloudy. The recent data on productivity indicates that any improvement in top line revenue growth could quickly translate into additional corporate profits. Additionally, Business Week recently published an article, The Painful Truth about Profits, bemoaning the outlook for corporate profitability. While not the 20^th Anniversary issue of the "Death of Equities" cover story published in mid 1982, it’s close enough for government work. Similarly, even though the yield on the S&P 500 is still only 1.8%, it is 1-1/2 times the yield on the three month Treasury bills, a ratio similar to other market bottoms. Any reduction in the double taxation of dividends combined with any improvement in corporate profits could lead to higher dividends.

Stocks usually react to the Fed’s reduction in rates but certainly not recently. Shown below are the thirteen reductions in the discount rate (from 6% to 0.75%) since the end of 2000 compared to the S&P 500. Not a pretty picture. (Is it different This time?)

In spite of the worst bear market since 1973-1974 (if not the 1930s), the 10-year return on stocks is not far from the long-term return on stocks of 9%. Most of this bear market decline has been a painful retraction of the excesses of the bull market preceding it. From Montgomery Brothers’ viewpoint one of the most encouraging aspect of the current environment is the near record numbers of SELL recommendations emanating from Wall Street. Since there were virtually no SELL recommendations when you should have been selling, we wonder if lots of SELL recommendations might be a good indication that it’s now time to BUY.

November 11, 2002      John E. Montgomery
 

Some charts courtesy of Baseline.