What with the War with Iraq, fears of terrorist threats, a sluggish (near recessionary) economy, slumping consumer confidence, and a seemingly never-ending bear market, it’s no wonder that perennial optimist and unarguably good guy Fred (Mr.) Rogers checked out during the first quarter of 2003. We’re all familiar with Murphy’s Law, but the first quarter of 2003 proved Murphy’s Corollary—that Murphy was an optimist. And many think that it gets worse from here.

In spite of widespread opposition from the United Nations and many of our allies, and growing doubts among some Americans, the United States has gone to war with Iraq. President Bush is committed to preventing another September 11th type incident. Apparently he believes that if 19 guys can hijack 4 planes, fly them into the World Trade Center Towers and kill 3,000 people, who knows what would be possible if enemies of the United States got a hold of Weapons of Mass Destruction (WMD). While it has yet to be conclusively proven that Iraq has WMD, who really doubts it? And, even though Saddam’s ties to terrorists appear tenuous, it seems folly to Bush to take a chance that Saddam might arm and assist terrorists. So off to war we go! While many, us included, felt that toppling Saddam would be relatively easy, it, unfortunately, hasn’t been. So now we are all watching the ultimate in "reality TV" and wondering if something hasn’t gone wrong.

War is not a good backdrop for the economy, and Bush is desperate to get the economy going for the 2004 presidential campaign. As if the Democrats weren’t giving him enough fits, the Republican controlled Senate recently slashed his tax cut proposals in half following his requests for $74.7 billion (why not make it an even $75b?) to pay for the Iraq war. Bush scolds Congress about its profligate spending, then proposes a huge Medicare prescription drug program that is supposed to cost only $400 billion over the next ten years. While the president has wisely straight-armed the governors of free spending states facing huge budget deficits, far too often he has caved in when friendly politicians came seeking federal spending largesse. We are now faced with the specter of the administration explaining to us on how waging war and increasing spending for homeland security can help stimulate the economy. Forecasts of multi-hundred-billion-dollar budget deficits stretch into the nebulous future.

The American people are a pragmatic lot. We address problems as they arise. This is especially true with politics. We’ve been told for years, decades, that Social Security and Medicare will go broke. Everyone knows it’s true. But we just keep increasing Social Security and Medicare benefits. Saddam Hussein is a bad guy. No doubt the world would be better off without him. But since he’s not inside the "Beltway" quite yet, we shouldn’t be too concerned. Or, at least, this is what the anti-war crowd would have us believe. Regardless of what you think about the current administration, the War with Iraq, homeland security, deficit spending, etc. etc., if Bush doesn’t get the economy turned around soon, the regime change he’ll experience might be his own.

As far as the economy is concerned, Montgomery Brothers is not sure whether the War with Iraq is the main show or a sideshow. Unfortunately, it might not make much difference because all of the war uncertainty is starting to inflict real damage on what MBI has viewed as a fairly resilient economy. We’ve been impressed at how well the US economy has weathered the bursting of the stock market bubble, the tech/telco capital spending bust, the corporate scandals, and the aftermath of the September 11^th attacks. The recession was mild. In spite of the contraction in economic growth which occurred during the first, second, and third quarters of 2001, the year 2001 as a whole actually saw (statistical) economic expansion as you can see from the data below.

Consumers, in spite of never-ending forecasts that they’ll soon stop, continue to spend. Sooner or later, probably later, consumer spending will flag but, my-oh-my, how consumers love to spend! Meanwhile business has virtually ceased new capital expenditure and continues to manage inventories on an "as needed" basis. The trade deficit shows no sign of shrinking, let alone reversing. Increasingly people are looking to Washington to prime the economic pump, as if going from $200 billion surpluses to $200 billion deficits isn’t expansionary!

Mercifully, the underlying economy remains relatively strong in spite of all the "doom and gloom." But eventually, the cumulative effects of the war will further weaken the economy.

Much is being made of consumer confidence, which is at the lowest level since the last Gulf War, which also was the last time that we experienced a recession and a bear market. Shown below are the questions upon which the Conference Board Survey of Consumer Confidence is based.

1. Respondents’ appraisal of current business conditions.
2. Respondents’ expectations regarding business conditions six months hence.
3. Respondents’ appraisal of the current employment conditions.
4. Respondents’ expectations regarding employment conditions six months hence.
5. Respondents’ expectations regarding their total family income six months hence.

Meanwhile, during the 12 months ending in February 2003 nearly 1 million people became employed in the United States. During this time, the average weekly salary for all 136 million people who were employed rose by 2.9%. (Personal and disposable incomes rose even more.) So while consumers were (egads!) saving more, it didn’t mean that consumer spending was about to come to a screeching halt. Is it really that awful that consumers are saving as well as spending? Even though an end to the Iraq war might assuage consumers’ confidence, MBI doesn’t believe that consumers will change their spending habits very much as a result.

Similarly, when the war does end, it is unlikely that business people will change their current tortoise-like spending strategies. Capacity utilization remains low, discouraging capital spending; inventories are likely to be maintained at minimal levels; additional hiring just increases costs at a time when cost cutting remains in vogue; and, (besides) in the current corporate climate, why be a hero since if you fail you are either a fool or a knave?

Foreign economies remain in the tank so MBI expects little help on the trade front. Even if the dollar does fade, we doubt that the United States will experience any significant pickup in export activity. Similarly, given the current political climate, there’s little reason to expect much additional fiscal stimulus since (a) state and local governments are cutting spending and/or raising taxes to close their budget deficits, and (b) deficit phobia at the federal level precludes adequate counter-cyclical federal spending and/or, better yet, tax reductions to stimulate the economy. Additionally, most counter-cyclical spending increases tend to become permanent, and much of what politicians consider stimulus is more counterproductive vote buying than counter-cyclical fiscal stimulus.

When the war does end, nothing is likely to happen. No second (or double dip) recession. No big economic rebound. Just more of the same slow growth, stop and go economic limbo. In MBI’s opinion, the war’s uncertainty is just a convenient excuse for consumers, businesses, and government to wallow in self-pity and inaction.

If Alan Greenspan and the Federal Reserve are serious (and even if they’re not) in believing that the war’s uncertainty is holding back the economy’s expansion, we shouldn’t expect much more in the way of interest rate reductions any time in the foreseeable future. If the war ended tomorrow, it would take months before the Fed could fire any more monetary blanks.

Earlier we mentioned that the American people are quite pragmatic. The low interest rate environment is yet another example. Consumers continue to take advantage of near record low interest rates by refinancing their mortgages at near record levels. Corporations, similarly, are locking in low rates by refinancing corporate debt. But not our federal government! By continuing to finance more and more of our once again rapidly expanding federal debt by the use of short-term paper, we are creating a potential time bomb when interest rates go back up, even while saving interest rate costs in the shorter term. But, like Social Security, we’ll worry about this time bomb later.

The yield curve, shown below, indicates that economic growth should accelerate, and/or interest rates should rise rapidly, and/or inflation should accelerate. But the yield curve said virtually the same thing six months ago and "none of the above" have happened.

Montgomery Brothers believes that inflation is a monetary phenomenon caused by central banks creating too much money. So far in this cycle the excess liquidity created by the Fed has disappeared into a deflationary black hole. (Think telecommunications and airline bonds!) Meanwhile as you can see from the chart below, recent price indicators have weakened making us even more sanguine on inflation over the short term.

Nevertheless, interest rate risks are high. The monetary and fiscal powers that be would rather face inflationary than deflationary problems. Unless the economy crashes back into recession or rebounds to a much quicker expansion than MBI believes is likely, interest rates are likely to stay about where they currently are, perhaps with a slightly upward bias over the next quarter or so.

Happy*!?*!* Birthday! March 10 and March 24 were the third anniversaries of the all time highs for the NASDAQ Composite and the S&P 500, respectively. (The Dow Jones Industrial Average had its all time high on January 10, 2000.) Since those dates the Dow, S&P 500, and NASDQ are down by 31.8%, 44,5%, and 73.4%. Who says Y2K was a non-event?

As we all sadly know, the 1995–1999 Bull market turned out to be a huge bubble. Those of us who were new paradigm-doubting Thomases were amazed at how long and how high the bull market was able to climb. Even though we figured that it would end badly, we had no idea how badly! We only hope that the resultant bear market doesn’t have to go to such similarly extended extremes as the bull. It was, therefore, with the greatest of trepidation that MBI recently raised its forecast for the 2003 trading range for the S&P 500 from 750–950 to 800–1000. So did we ever feel smart, although lucky is surely the better adjective, when the S&P stopped declining at 800.73 on March 11, 2003 only to launch its largest one-week rally in 20 years. First, the stock market went up 275 (Dow) points on the hope that war might be avoided. Then, three days later, it went up 275 (Dow) points when the war started. Go figure! But when the war wasn’t over in a week, the second guessing began, and the market went down 300+ (Dow) points. Since then the stock market has been moving lower and looks likely to retest its recent lows.

What makes us nervous? In a nutshell, everything, but especially the negative impact of a prolonged war; the possibility of new terrorist attacks; a possible second (or double-dip) recession; but, above all, the probability of political screwups on fiscal and/or monetary policy.

Montgomery Brothers continues to believe that we’ve seen the lows for this bear market but is equally convinced that a raging bull market does not lie ahead. It is likely that there will be a rally once the war ends. And, the sooner, the better! However, after the initial euphoria wears off, we expect more of what we’ve been experiencing for the past six to nine months as the market completes its bottoming process. Some protest that the market is still too expensive but, as Steve Leuthold points out, most bear markets stop declining at "average" valuations and seldom go to extreme undervaluation. Additionally, there are several positive indicators that we see. From a contrarian point of view, "investors" continue to sell equity mutual funds (another $11 billion in February) and buy bond mutual funds (another $19 billion in February), and the majority of advisory sentiment remains bearish. Corporate profits, as reported by the Commerce Department, were actually up by 4.1% during the fourth quarter and by 10.3% since the fourth quarter of 2001. Most companies are lean and mean, and any additional sales are likely to flow through to the bottom line. Even though MBI is not as optimistic on the earnings outlook as, say, the average wire-house strategist, we don’t have to be overly bullish to keep our jobs. Additionally, after years of reporting phoney-baloney earnings from the bull markets’ effect on corporate retirement plans, corporations will probably have to make real money contributions into such plans in 2003. Estimates range upwards of $150 billion. At any rate, it could produce a lot of marginal new demand for stocks. Lastly, insiders are starting to buy more of their own company shares which MBI always views as a major positive indicator.

MBI remains underweighted in the technology sector. Even though the stock charts look good, the fundamentals look awful. We view the tech stocks as the "cyclicals" of the early twenty-first century. Buy ’em when they have low (or no) P/Es, and sell ’em when they have high P/Es as the economy and their earnings improved. Until we see a new, new thing, MBI will underweight the tech sector. On the other hand, we continue to like companies that have decent, well-covered, growing dividends. Even though we believe that the elimination of the double taxation of dividends is politically DOA, MBI likes income. Historically, dividends have provided 40% to 50% of the total, long-term return from stocks. With interest rates at 40-year lows, it doesn’t take much for equity yields to be competitive. Additionally, while there are no guarantees, MBI feels that earnings are more likely to be "real" if some are paid to shareholders through dividends.

April 1, 2003   John E. Montgomery

Some charts courtesy of Baseline