Tom Cruise would be proud. Sometimes you’ve just got to say "What the Heck!" During the past couple of years, investors have been trying to reduce their stock market risks. However, since the rally that began in March, investors have once again been embracing risk. In doing so, they join our politicians who have inadvertently been increasing the risks to the US economy. Much to the chagrin of most of us, the 2004 presidential elections are already well underway. Only 16 months until election day! As they vie for our votes, our politicians will be wowing us with all the great things they will be doing for us. We wonder at what long-term costs?

The last several presidential elections have been decided by a small sliver of "moderate" voters who are in the middle of the political spectrum. While most presidential candidates have been trying to woo these middle-of-the-road voters, it seems that the Democrats might be going on a different route for 2004. Several of the, currently, nine Democratic presidential nominee contenders are trying to pull the party to the left, or liberal side, of the ledger. Given the beatings that left-leaning Democratic presidential candidates received in 1984, and again in 1988, and the success of Bill Clinton’s "moderate" appeal in 1992, and again in 1996, this seems to be a pretty risky proposition.

George Bush, who currently is an odds-on favorite for reelection, is taking the more traditional centrist path. Having sown up his conservative base, the president seems to be looking to capture the middle. Prior to the 1996 presidential election, Bill Clinton stole the traditional Republican issue of "welfare reform." By passing welfare reform legislation, Clinton took welfare off the table and claimed the middle ground as a "moderate" Democrat. Bush is now trying much the same tactic with his Medicare prescription drug benefit proposals. Passage of this legislation would take this issue off the 2004 table and rob the Democrats of one of their most potent and long-running presidential issues. It would also bolster Bush’s "compassionate conservative" (whatever that is) credentials, thereby increasing his appeal to moderate voters.

But more than the 2004 presidential election is at stake with this risky tactic. Bush hopes to "run the table" in 2004 and pick up Republican seats in both the House and Senate. Ideally, by Bush’s calculations, the Republicans would end up with at least 60 senatorial seats, giving them a filibuster-proof majority and clearing the way for judicial appointments and other conservative initiatives. Regardless of what one might think of his politics-over-principles tactic, there is great risk in Bush’s Medicare gambit. Like Social Security, Medicare is a runaway fiscal train. By adding another "entitlement" benefit to Medicare, President Bush runs the risk of opening the floodgates to ever more social spending. One thing that MBI knows for sure is that if the estimated costs of the prescription drug benefit is projected to be $400 billion over 10 years, it will be at least twice that amount. When added to the estimated "cost" of $350 billion in tax "relief" recently passed, we’re facing some pretty formidable budget deficits. "Starve the beast" indeed!

As I believe we’ve mentioned before, the recent/current economic downturn is unlike previous recessions. Housing and autos, as well as retail sales, in general, have remained robust throughout this economic "soft patch." Most of the economic weakness has been, and continues to be, centered on the huge downturn in business spending, especially for technology and telecommunications equipment and services. These are the economic sectors where the majority of the excesses from the late 1990s "bubble" economy were concentrated. Montgomery Brothers believes that what the economy really needs is TIME. Time to recover from the bubble. Unfortunately, time and patience are not very politically palatable.

Since continued economic weakness is President Bush’s reelection Achilles heel, he has turned toward as high a stimulative fiscal policy as he could get passed by Congress. When combined with the stimulative monetary policies currently being pursued by the Federal Reserve, there is a risk that, rather than stepping on the gas, all of this economic stimulus might flood the engine. Unfortunately, only time will tell.

Since there is little in the way of pent-up consumer demand and little likelihood of an increase in capital spending, the Bush administration is, in our opinion, attempting to manipulate the financial markets in order to stimulate the economy. The reduction in capital gains taxes and the lowering of the tax rates on dividend income is meant to increase stock market values. The Fed’s lowering of interest rates has already led to a huge appreciation in bond prices and home values. Any increase in "wealth-effect" could lead to higher consumer confidence which should lead to even more consumer spending. This in turn could, as it almost always has in the past, lead to additional business spending both to increase inventories and to expand capacity. Unfortunately, only time will tell when (or even if) this might happen!

The consensus economic outlook continues to be that the currently muted expansion will pick up speed during the second half of 2003 and into 2004. Such a scenario used to be called the "presidential cycle." This would be great – especially for President Bush’s re-election bid.

Thirteenth time’s a charm! With the Fed’s most recent cut–it’s thirteenth–interest rates are at 45-year lows. Montgomery Brothers believes that this cut will turn out to be more overkill than taking out insurance against deflation. There was a time when questioning Alan Greenspan’s policies was tantamount to badmouthing motherhood, but no mas. A recent Wall Street Journal editorial page article by economist Brian Westbury (copies available upon request) spelled out the cons of cutting rates. The press is increasingly skeptical of Sir Alan. For better or worse, Greenspan’s reputation remains largely intact, and it is highly likely that he will be re-appointed chairman of the Fed. Greenspan will set some sort of dubious achievement award for central banker longevity and allow us to continue to experience the same monetary policy dexterity that we’ve grown accustomed to over the last half dozen or so years.

There are risks in such low interest rates, not the least of which are the miniscule earnings that savers are currently receiving on short term deposits. Additionally, the banking and financial industries are likely to become less profitable in this progressively lower interest rate environment. Japan has had tiny interest rates for years with no stimulative success.

Keynes spoke of a "liquidity trap" that could occur when interest rates were lowered and yet insufficient economic activity resulted. This is exactly what happened during the Great Depression and more recently in Japan. MBI believes that it is the Fed’s intention to force investors to extend the duration of their portfolios. There is currently in excess of $5 trillion in money market investments, which will soon, if they’re not already, be earning less than 1% annually. In search of higher returns, investors are likely to buy bonds and stocks in an effort to increase their returns. This entails taking a higher degree of risk than many investors are accustomed to or comfortable with taking. Generally, liquidity, such as that being provided by the currently stimulative monetary policy, initially finds its way into financial assets and then, later, into the real economy. This is what has happened in the past, but didn’t during the Great Depression and hasn’t in Japan. Such a "liquidity trap" is what the Fed is hoping to cut off at the pass.

Montgomery Brothers has either been early or been wrong with our cautious stance on bonds. (We hope that we’ve been early.) The low level of interest rates makes bond ownership quite risky and the Fed’s fly-by-the-seat-of-the-pants deflationary policies are highly problematic. The day before the Fed’s most recent interest rate cut the 10 year US Treasury was yielding 3.29%. At the end of June, it was yielding 3.51%. This resulted in a decline in value of approximately 7.5% in the price of the 10-year bond in a mere four trading days. The price decline would have erased nearly two years of income earned on the 10-year US Treasury. And people don’t think bonds are risky!

If, as MBI hopes and expects, economic activity does pick up, as it always has after massive doses of monetary and fiscal stimulus have been applied, interest rates will go up, eventually. Even though the Fed has implied that it will hold interest rates low until it is sure that economic growth is accelerating (watch employment which is a lagging economic indicator), the bond market will move ahead of the Fed. The recent rise in longer-term interest rates and steepening of the yield curve which occurred after the Fed’s most recent cut in interest rates are, in our opinion, signs of things to come.

MBI is unimpressed by the Fed jabbering about deflation. Deflation is unlikely, in general, but even less likely when gold and commodity prices are rising and the dollar is declining. See the charts below.

We believe that the Fed is using deflation as a cover for continuing to follow its current stimulative policies. While such blatant market manipulation is potentially beneficial to bond and stock prices, and ultimately the economy over the short to intermediate term, it is not without risks for the longer term. Stealing economic growth from the future and trying to fool the financial markets could, and probably will, come back to haunt us.

While MBI has been getting progressively more positive on the stock market during the past couple of quarters, we have been surprised and impressed by this most recent rally. We still believe that more time is needed to complete the bottoming process but reiterate that we believe that we saw the bottom for this Bear market cycle last fall. Nevertheless, the S&P 500 is at the top of our forecasted 2003 trading range of 800 to 1000 (see chart below) and we urge short-term caution.

Nevertheless, we are raising our targets for the next six to twelve months to a range of 840 to 1050 on the S&P 500 and are recommending to those underinvested in stocks to use weakness to augment positions. Here’s why:

But while we see lots of positives, we’d be remiss not to mention the negatives which we see. These include:

Our bottom line is that we are cautiously optimistic. A pullback would be a welcome relief to us, especially if the internal market technicals remained positive while psychology became more negative.

Montgomery Brothers remains stand-offish on Technology in general, and we are under-weighted in that sector. We are over-weighted in the Health Care sector and roughly evenly weighted elsewhere. Our antidote to risk is to continue to concentrate on buying conservative, dividend-paying stocks that have some sensitivity to economic expansion; to concentrate on investing in smaller capitalization issues; to focus on companies with revenue and unit volume growth; and, to stress buying into companies that are generating economic, not necessarily G.A.A.P., profits.

Lastly, the reductions in capital gains and dividend income tax rates are HUGE long-term positives. But these tax law changes, along with underlying changes in the economic and stock market dynamics, require changes to one’s investment strategies. These will be the subjects of our next Investment Outlook.

July 1, 2003   John E. Montgomery

Some charts courtesy of Baseline