Mid-Third Quarter, 2003
Investment Outlook Update
August 15, 2003

"Ahhnold"

The colorless Gray is being run out of town, actually the state, on a rail due to the California economy. Nevermind, that it’s not all Davis’s fault or even that he can do much to rectify the situation. The same fate could befall President Bush should the U.S. economy continue to muddle along. Or, so hope the Democrats. A recent Pew survey indicates that the economy and unemployment now overshadow voters’ concerns about terrorism. This probably means that the worst is over for the economy and the recent data indicates that it is. If, as they say, the election were held today, Bush would win in a landslide. The Washington Post recently found Bush’s popularity stabilizing at relatively high levels. But, with the Peace in Iraq going poorly and the economy by no means out of the woods, November 2004 is a long way off. Meantime, we can all sit back and have a few good laughs at California’s expense.

Fortunately for George W. Bush, the economic news is starting to improve. Lord knows, the President’s father was roundly criticized for having been "asleep at the switch" and losing the 1992 election to Bill ("It’s the economy, stupid") Clinton. (Does the name Ross Perot ring a bell?) The same won’t be said for W. If anything, he cares too much about the economy. Or, perhaps more accurately, he cares a lot about how a weak economy could keep him from being reelected. A la Poppy!

So he’s engineered tax cuts, stepped up government spending, and encouraged the highly expansionary monetary policy of the Federal Reserve. While MBI fears these actions could lead to a flooding of the economic engine over the longer term, it’s really only the next fifteen months that appear to count to this administration. And, the financial markets.

Happily for Bush & Co., the economy looks to be on the mend. Second Quarter GDP was initially reported at a 2.4% annual rate.

70% of 2Q ’03 GDP growth came from the largest quarterly increase in defense spending since the Korean War. With the Iraqi war (kind of) over, MBI expects no instant replay on defense spending. Nevertheless, with wallets plumped by tax cuts and incomes continuing to grow in spite of no growth in employment (yet), consumer spending should continue to expand. The recent 1.4% increase in retail sales leaves the inventory cupboard a little bare and could spur some longed-for improvement in the manufacturing sector. None of this has been lost on those eagle-eyed sleuths at the National Bureau of Economic Research who declared on July 17^th that the recession had, indeed, ended in November … of 2001! Granted the current recovery has been subdued, but so was the preceding eight-month long recession.

The press has been all over the recent improvement in the economy. For example, the Wall Street Journal recently ran a front-page article "As U.S. Shows Signs of the Growth, Global Economies Look Up, Too." Gosh, wasn’t it just before the stock market rallied by over 20% that most of the press, many economists, and even some Wall Street pundits were hanging black bunting on the economy? Forecasting quarter-to-quarter GDP growth is a sticky wicket but the economic consensus is now calling for a gradual improvement in the rate of economic growth with second half 2003 GDP of around 3.5%. MBI continues to wonder about the lack of pent-up demand for autos and housing, and how much of the demand for consumer goods will be met by imports. Additionally, while inventory building is likely, capital spending is less likely, given the still high levels of idle capacity. Historically, stimulative monetary and fiscal policy, to the degree that we are currently experiencing, have led to robust growth. The uptick in interest rates and the rally in the stock market indicate that a significant pickup in economic growth is possible. Many are saying that "this time it’s different" but this has recently been a one-way ticket to Palookaville.

Friday the 13^th (of June, 2003) might have been the end of the secular bull market in bonds that started way back in the early 1980s. The spike DOWN in interest rates that occurred from mid-2002 to nearly the end of the second quarter of 2003 took rates to lows not seen in over half a century. MBI sees a lot of similarities between the spike down in interest rates and the terminal bull market blow-off of stocks in 1999 and early 2000. (Did someone say "bubble"?)

The final move down in interest rates came during a period of near despair over the economic outlook and talk about deflation. Given the highly counterproductive proclivities of politicians, it is possible that the U.S. could go the way of Japan, but it is highly unlikely. The stock market rally followed by signs of a nascent economic recovery snapped the bond market out of its "we’re going to have a deflationary depression" bias. MBI actually views the upturn in interest rates as a positive for the economic and stock market outlook, but certainly not for the bond market.

This is the point in this update where we planned to hammer Alan Greenspan for his ham-handed handling of monetary policy, but why? This guy’s star is dimming rapidly anyway and, while we surely believe he had much to do with creating the "bubble," we’re not sure what else he could have done to cushion the inevitable bursting of said "bubble." Besides, while Greenspan and the Fed are widely believed to have super-hero powers akin to those of Schwarzenegger movie characters, such beliefs are poorly founded. There is great power in the Federal Reserve Monetary toolbox, but the Fed really only influences the shortest end of the yield curve. The Fed can’t control the economy and its influence on the longer end of the yield curve is far less than widely perceived. Influential? Yes! All-Powerful? No!

MBI remains highly dubious about the probability of deflation. Given the decline in the dollar and the increase in precious metal prices over the past two years, we are more concerned with inflation making a comeback. Inflation is a monetary phenomenon and, Lord knows, the Fed had been creating lots of dollars with its expansionary monetary policy. The decline in the dollar and the increases in precious metals prices reflect, at least in our opinion, a perception that the dollar’s value is declining. That’s inflation, not deflation. With the economy and stock market improving, whatever deflationary pressures might have existed are likely to abate. The more traditional, and lagging, indicators of inflation will take much longer to develop.

In MBI balanced accounts we have reduced our exposure to bonds and have shortened the duration of our holdings. We continue to prefer corporate bonds and agencies to Treasuries, and prefer TIPS (Treasury Inflation Protected Securites) to regular coupon or zero-coupon Treasuries. Even though the Fed has told us, emphatically, that short-term rates will remain low until further notice, we’ve already seen how little impact the Fed has on longer term yields, especially if the market smells a rat.

Stock Market Outlook

During the recently-ended bear market, people would often ask us what it would take to get people interested in stocks again. Our answer was always "A 20% to 30% rally!"

As you can see from the chart of the S&P 500 index shown above, the stock market put in a triple bottom between July of 2002 and March of 2003. From the March 2003 lows, the S&P rose 25% before entering into its recent narrow trading range. Bingo! People are interested in stocks again, investment advisors’ sentiment has turned bullish, and money is flowing into equity mutual funds.

Should interest rates continue to rise, and we expect they will, stocks will face considerable competition from bonds. However, as MBI has pointed out before, we believe that corporate profits trump interest rates in the direction of stock prices. And here the news is encouraging. Second quarter results were generally better than expected although, after years of disappointments, the bar had been set fairly low. While nothing to write home about, revenues and earnings for the S&P 500 were up on a sequential basis and about even year to year ago levels. The stock market often does best when results stop getting worse rather than when they start getting better.

There is still plenty of skepticism about this rally and stocks remain richly priced on traditional valuation parameters. A recent Wall Street Journal column questions second quarter results, in general. Additionally, insiders remain skeptical and insider selling swamps buying by a huge margin. This IS a big concern to us but not insurmountable. MBI continues to be impressed by how well the market is digesting its recent rally and continue to view pullbacks as buying opportunities. We remain standoffish on technology although increasingly favor economically sensitive industries, other than auto and housing.

As we’ve mentioned, before we expect that the markets will return less on an annual basis than they did during the secular bull markets of the 1980s and 1990s. Additionally, MBI believes that the stock market will be in a volatile trading range, but now with an upward bias. We are once again raising our target for the S&P 500 for the remainder of 2003 to a trading range of 900 to 1050.

MBI does not give tax advice but the recent changes in the tax laws have caused us to fine-tune our strategies to take these changes into consideration. The reduction in the long-term capital gains rate to 15% and the reduction to 15% for the taxation of "qualified dividend income" leads us to increase our preference for using taxable accounts for most equity investments. The reduction in capital gains rates makes long term gains even more valuable but, given high volatility and increasing trading range nature of the stock market, shouldn’t preclude one from taking short-term gains. Additionally, since all money withdrawals from retirement plans are taxed as regular income, fixed income and dividends that aren’t qualified (e.g. MLPs and REITs) should be purchased in retirement plan portfolios. (If you’re really clever you could buy all your short-term gain positions in your retirement account but remember that losses do you no good in such plans.) Alas, the Alternative Minimum Tax (AMT) lives on, and will play havoc with tax planning. You’d better consult your tax lawyer or accountant since the AMT is something not even the "Terminator" can handle!

August 15, 2003   John E. Montgomery

Some charts courtesy of Baseline