Mercifully, the war in Iraq ended quickly and with minimal loss of life. After a somewhat shaky start, U.S. forces quickly dispatched the Iraqi army and Republican Guard. Since no one on the Iraqi side was available to surrender our President Top Gunned it to the aircraft carrier Abraham Lincoln and declared victory. Now, like Osama Bin Laden and Carmen San Diego, people can wonder where in the world is Saddam Hussein?

As was the case with the Soviet Union in Eastern Europe and in All-them-stans, Saddam Hussein repressed all of the various ethnic and religious groups in Iraq. And, like in Eastern Europe and in All-them-stans following the fall of Communism, the various factions in Iraq have decades of ethnic and religious bloodletting to catch up on. The Baathists hate the Islamic Fundamentalists, the Shiites hate the Sunnis, and the Kurds hate the Wheys. After a brief celebration at Saddam’s fall, the various Iraq factions started feuding among themselves and about the only thing they can agree on is that they’d like to get the U.S. out of their country. Pronto! If Afghanistan is any indication, winning the war could prove easier than winning the peace.

Similarly, after a brief period of bipartisan support for our troops, the Democrats and Republicans have returned to their intramural squabbling. Whether appointing judges, stimulating the economy, or addressing long-term issues such as Social Security and Medicare, scoring political points takes precedence over solving national problems every time. When they speak about irresponsibility, our politicians know what they’re talking about!

About the only thing that the Democrats and Republicans can agree on is that beating up corporate executives, in general, and Wall Streeters, in particular, will score political points aplenty. So even though a myriad of existing laws was broken, a whole slew of new laws and regulations lie ahead. And, regardless of the fact that the free market capitalist system is moving quickly to remedy the excesses of the late 20^th century Bubble, a regulatory reign of terror is upon us. In their efforts to show their concern and look as if they’re doing something, lots of legislative sand will be poured into the gears of our economic machine. This will increase the costs of raising capital and, in all likelihood, further retard an already anemic expansion.

While what our economy needs is time and patience, our politicians are hell-bent to give it a stimulus. The Republicans want to stimulate the economy by giving tax breaks to the wealthiest 10% and the Democrats want to give more and more taxpayer money to the lazy and profligate. Or so each side would have us believe of the other. But they do agree that the budget deficit should not be allowed to grow much, if at all. This will make stimulus more than a little difficult. Nevertheless, taxes will be "cut," spending will be increased, and (through accounting so creative that it would make even the most aggressive private sector accounting chef blush) the budget deficit will be forecast to shrink sometime in the nebulous future; a.k.a. the "out years."

Meanwhile, obvious long-term demographic time bombs like Social Security and Medicare tick on. But since raising FICA taxes or reducing benefits is out of the political question, our politicians have to be innovative. Their solution? An expansive and expensive new Medicare Drug Benefit Program. (Why didn’t we think of this?) The U.S. is increasingly acting like socialistic European countries or, even worse, Japan. Is it any wonder that the Dollar has been declining in value relative to the Euro and the Yen?

Predictably, consumer sentiment soared at the end of the war. But since there is little or no correlation between consumer confidence and consumer spending, there has been little in the data to indicate a quick economic rebound following our "victory" in Iraq. Unsurprisingly! The economic statistical mills are not overly accurate, are subject to massive revisions, are hobbled with questionable seasonal adjustments, and are generally backward looking. Besides, the uncertainty caused by the Wars (Iraq and Terrorism), the first quarter of 2003 was fraught with lousy weather and influenced by the lingering effects of the bursting of the "Bubble." Is it any wonder that growth was anemic?

As you can see from the chart below, quarterly GDP growth has been highly volatile during the recovery from the most recent recession.

Montgomery Brothers continues to forecast sub-par economic growth in a low inflation environment for at least the next several quarters. While others are rapidly revising their economic forecasts downward to reflect the most recent data, MBI focuses on the longer term. Since quarterly GDP is largely influenced by changes in inventory, we believe that forecasting quarterly GDP is a fool’s game. We prefer to focus on somewhat longer trends and that’s why we’re forecasting continued slow growth.

Consumer spending has been strong for a decade, greatly mitigating the most recent contraction and contributing in a major way to the current recovery. But the consumer is due for a breather. Mercifully, we see some signs that businesses will increase corporate expenditure through inventory building and capital spending. But since the impact of business spending is less than 20% of that of consumer spending, our enthusiasm for economic growth is tempered. Fiscal policy will become even more stimulative but this will only be a slight plus to economic growth. The weakness in the dollar should increase manufacturers’ export business. The drop in the price of oil, which will also aid consumer spending, will combine with the weakness of the dollar to increase exports. This should lead to a minor improvement in the trade deficit.

MBI foresees better economic growth during the second half of 2003 but less than the now-declining consensus forecasts of 3.5% to 4.0% of GDP. And certainly no double-dip recession.

If Oscar Wilde felt that second marriages were the triumph of hope over experience, what would he say about the (probable) reappointment of Alan Greenspan to a fifth term as Chairman of the Federal Reserve? For whatever reason Greenspan continues to avoid blame for the 1990s "Bubble" and, in fact, is generally praised for having kept things from having been potentially even worse. An open and shut case of the devil you know.

In 1974 Greenspan was handing out Whip Inflation Now buttons while the economy slid into the worse recession since the 1930s. For a man who has spent his whole career as an inflation fighter, it is weird to hear him warn about the possibilities and potential pitfalls of deflation. This while many, if not most, continue to experience rising prices for medical care, insurance, education, real estate (especially real estate taxes), and many other daily expenses. But never mind that, what should be important to investors is the additional message that the Fed has NO plans to raise interest rates any time soon. In fact, the Fed has implied that short-term rates will be cut again if the economic recovery stalls and that longer-term Treasury securities may be purchased in an effort to reduce interest rates further. All in an effort to reflate the economy.

When you combine the continued expansionary monetary policy with a soon-to-be-even-more-expansionary fiscal policy, you have a whole lot of liquidity being pumped into the system. Given a slowly expanding economy, this provides the fuel for further advances in stock and bond prices. It also potentially sows the seeds of future inflation or, as Greenspan has warned, cushions the possible contractionary impact of deflation. Unfortunately, only time will tell which.
 

Like the improvement in consumer sentiment, the spirited stock market rally following the U.S. victory in the War in Iraq was widely forecast. This upswing, which actually started almost simultaneously with the beginning of theWar, is the third 20% rally since the bottoming process began last summer. (See the chart below.) Some have proclaimed this to be the beginning of a new bull market while others forecast that it is just another bear market rally. Unfortunately, only time will tell but, in our opinion, signs are much more positive than any time during the past three years.

Bonds have surpassed stocks as the financial asset of choice, yet the historical data suggests that it is time for a change in strategy. Annual bond returns were almost six percentage points greater than the stock returns for the five years ending 12/31/02. Recent data from the Charles Schwab Center for Investment Research shows that since 1926, after five year periods when equity returns have trailed bonds by such a large margin, stock returns have subsequently averaged almost 14% annually compared to 4% annually for bonds. Additionally, corporate profits appear to be improving. With nearly 90% of S&P 500 companies having reported first quarter results nearly two-thirds of companies are reporting positive earnings surprises albeit from reduced "guidance." Nevertheless, year-over-year earnings are showing a nearly 15% improvement. Even though valuations remain historically high, MBI’s research indicates that increasing earnings are a more powerful influence on stock prices than are declining interest rates. The last couple of years are a good example since stocks (whose earnings have declined sharply) saw a major bear market in spite of interest rates declining to 40+ year lows.

Expectations for both equity returns and earnings growth have become more reasonable, but the animal spirits from the Bubble are still evident. Once again, with little or no indication of fundamental improvement NASDAQ/High Tech stocks are leading the rally. Bullish sentiment has improved with the upmove and cash is again flowing into equity mutual funds after a long period of bear market withdrawals. In spite of all the seasonal hype about summer rallies, the period between May and September is traditionally weak. During the past 60 years stock returns have averaged 8.4% per annum between October and April but only 0.9% between May and September. As you can see from the chart above, the S&P 500 is back towards the higher end of our forecasted 800 to 1000 trading range. While MBI expects a pullback, we’ve been more encouraged by the technical underpinnings of this rally than the two earlier ones. So if the "Sell in May and go away" proverb proves correct this year it could present investors with a good entry point for stocks.

It’s time to be less defensive and move toward economically sensitive, industrial-type companies. Additionally, companies with above average earnings growth (formerly known as "growth stocks") will probably play catch-up to more value-oriented stocks. Since the peak of the Bull market to the lows of last summer, value has outperformed growth. Even though the "Peace" may be hell, we’re sure glad that the "War" is over.
 

May 14, 2003       John E. Montgomery

Some charts courtesy of Baseline