Abraham Lincoln once remarked that "you can fool some of the people all of the time, and all of the people some of the time, but you can’t fool all of the people all of the time." At the Gridion Club dinner on March of 2001, George W. Bush stated, "You can fool some of the people all of the time, and those are the ones you have to concentrate on." Most politicians, however, focus on trying to fool enough of the people enough of the time to get (re)elected. Even though the 2004 presidential election is more than a year away, the presidential candidates are at it full (fool?) throttle.

The entrance of retired General Wesley Clark brings the field of Democratic presidential candidates to ten, and there’s no telling how many might enter after the California recall election is over. Polls taken immediately after General Clark’s announcement show him as the favorite to win the Democratic Party nomination and that he would best George Bush if the election were held today. An even larger percentage, however, when asked about General Clark responded, "Who’s he?" The press loves to build up candidates only to tear them down. Our hunch is that Clark Wesley … er, Wesley Clark’s front runner status will have a short shelf life. Besides, haven’t we already tried a president from Arkansas who was a Rhodes Scholar?

The Democrats will have a tough time winning the presidential election championing a policy of raising taxes. Last year, Oregon voters overwhelmingly rejected a referendum to raise that state’s tax rates. More recently, Alabama voters similarly rejected having their taxes increased, in spite of that state’s huge budget deficit. Why, even the voters of Seattle rejected a 10-cent per cup of espresso tax to pay for increased spending on schools! Additionally, the Democratic candidates support larger government, oppose free trade and are generally pro-labor and anti-business. The global economic boom of the 1980s and 1990s was based on free markets, open trade, and limited government. Good luck, Democrats!

Meanwhile, George Bush continues to slip in the polls and his popularity rankings are plummeting. In spite of the fact that the incumbent usually slides during the third year of his term, and regardless of the fact that Democrats are woefully short of any original ideas, the press is increasingly tolling the bells for President Bush. We’re no fans of George Bush’s brand of Texas populism disguised as compassionate conservatism, but we’re not ready to shovel dirt on his political grave either. The economy is improving and likely will continue to strengthen into the second half of next year. We may even see some job creation, which would probably lead to some growth in incomes. A decent economy is a potent elixir.

The budget deficit is a possible political hobgoblin but, as you can see from the chart below, even though the dollar size of the deficit is at record levels, as a percentage of GDP it’s no larger than during Bill Clinton’s first term.

While Iraq will probably remain a problem for the president, economics almost always trumps foreign policy, especially since Iraq ≠ Vietnam, in spite of the press and Democrats’ spin. Economics trump foreign policy almost every time.

While we worry about the long-term impact of cutting taxes and raising spending, we doubt it will derail President Bush’s reelection. However, the financial markets will be periodically buffeted by the ebb and flow of the presidential campaign. When things look bad for Bush the markets are likely to be weak. When things look up for Bush that will be the direction for financial markets too!

The recent economic news has been more good than bad. Combined with the strength of the stock market, most economists are busily revising their forecasts upward. The National Association of Business Economists (NABE) consensus is now calling for 4% GDP growth in 2004 (up from its previous forecast of 3.6%). Economists have been fooled before by shifting economic statistics and false starts for the stock market, but this time they’re sure that the expansion is the real deal. And Montgomery Brothers tends to agree.

Fiscal policy has been highly expansionary with tax cuts putting billions of dollars into consumers’ pockets. Happily for the economy and George Bush, consumers are spending most of their newly disposable income. Second quarter ’03 GDP was recently revised upward to a 3.3% annual rate from the earlier announcement of a 3.1% quarterly increase, which had initially been reported to be a 2.4% increase. (Upward revisions normally indicate strengthening underlying fundamentals.) Consumer spending during the second quarter was nearly twice the rate of the first quarter of 2003 when GDP grew by only 1.4%. And the tax cuts didn’t even take effect until July. Recent spending data show that consumers like tax cuts and are spending liberally. Gosh! Why would you save your tax cut when short-term interest rates earn you less than 1% annually, before taxes and inflation?

The consumer has been willing and is now even more able to keep the economy moving forward but could sure use some help from the corporate sector. Maybe, just maybe, business people are starting to stick their heads up from their foxholes. Earlier economic dawns proved false and corporate execs are reluctant to look foolish by cranking up spending in anticipation of an improving economy. They need to be able to see the light. Inventory liquidation took almost a full percentage out of GDP growth during the second quarter but non-residential investment, which is a proxy for capital spending, actually improved. With consumer spending strong and inventories at very low levels, corporations will eventually need to replenish their inventories. Orders have been on the uptick recently and business confidence surveys, especially among small business owners, indicate light at the end of the tunnel. MBI doubts that it’s yet another train. There is no doubt that the recovery from the recent recession has been subdued, but so was the recovery from the 1991 recession. That recovery became the longest peacetime expansion on record. Some tell us that "it’s different this time," but we’ll see if we all get fooled again.

Alan Greenspan’s popularity remains high. Fifty-four percent of respondents to a recent poll view Greenspan positively, while only 10 percent view him negatively. (The rest confuse him with Wesley Clark.) Interest rates are at half-century lows so the borrowing costs for business, consumers, and government are at the lowest levels in memory. Unfortunately, so are the returns on over $7 trillion currently invested in short-term money market instruments. Alan and the Fed have told us, emphatically, that short-term rates are likely to stay low for a long time, and Montgomery Brothers believes them. What is implicit in the currently expansive monetary policy of the Fed is that if you’re satisfied with a less-than-1% return on your investment before taxes and inflation, that’s your fault.

Having propped up consumer spending with low mortgage rates and zero percent auto financing, the Fed is now (not so?) subtly trying to manipulate the financial markets in hopes of improving the economy through the "wealth effect." It might be working. Over the past year, bond prices have risen sharply even after the beating that was administered to bond owners during the third quarter. More importantly, in our opinion, the value of the Wilshire 5000 was up by almost $1.6 trillion from the end of March to the end of September. That’s a 20 percent improvement!

The increase in the value of stocks and bonds leads to greater consumer confidence and spending, not necessarily in that order. It also helps improve corporate balance sheets while reducing corporate retirement plan underfunding. MBI sees initial signs of an incipient capital spending revival which would be good news for the economy and outlook for employment. Unfortunately, it might not be such good news for interest rates. The continued strength in the price of gold and the continuing weakness in the value of the dollar are early warnings of potentially higher interest rates. Additionally, the beggar-thy-neighbor weak dollar policy seemingly being embraced by the Bush administration is worrisome. Combined with growing global protectionist sentiment, one can only wonder if anyone remembers the devastating effect of such policies in the 1930s. MBI continues to reduce the bond exposure in the portfolios that we manage, and to shorten the maturities of the bonds that we buy and own for our clients. While we don’t expect interest rates to rise substantially, we fear that surprises are likelier to be on the upside.

Alcoholics Anonymous says that the two worst enemies of recovering alcoholics are good health and short memory. And so it seems with stock market investors. Following the drop in the market in early 2000 and the subsequent bear market which lasted until late 2002/early 2003, many investors took the pledge. Or at least swore off the hard stuff of technology stocks. But the intoxicating appeal of "easy" money has led many to belly up to the stock market bar, again.

During the Bear market when we were asked what it would take to get the individual investor interested in the stock market again, we always responded "a 20% rally." There were several false starts between April of 2000 and March of 2003 but those rallies tended to be over quickly then quickly reversed. It really wasn’t until the recent rally off the March (2003) lows that very many started talking about a new Bull market. There are now many true believers. Bullishness is rampant. Money is pouring into equity mutual funds (again), margin debt is expanding (again), day trading is back in vogue (again) and Wall Street is hiring (again). With short-term interest rates at or below 1% and the bond market looking a little wobbly, stocks are viewed as the "only game" in town. Sigh!

MBI has often stated that interest rates and earnings are the two primary drivers of stock prices, but that earnings are the more important of the two. We’re about to see if we’re right. Since interest rates are likely to be flat to up over our forecasting horizon, we’ll get to see if and how earnings drive the market.

MBI’s working thesis is that if the economy expands at a 4-5% pace during the second half of 2003 and into 2004 that corporate revenues, in general, will expand at roughly the same rate. We feel that, over the long term, corporate profits will expand only slightly faster than revenues. But… corporate executives are currently quite cautious. Having been fooled by the "new paradigm" of the late 1990s and now largely viewed as scalawags, if not common criminals, corporate executives are more than a little gun-shy. They aren’t hiring, they aren’t doing much capital spending, they aren’t even rebuilding inventories. Until they do some or all of these things their bottom lines will be leveraged to their revenue growth. Therefore, MBI believes that equities face a couple of quarters of above trend earnings growth.

What we don’t know is whether or not earnings will be as good as investors collectively expect, but we acknowledge that expectations are high. We are less scared off by high valuations than we were earlier in the cycle because (a) we have acclimatized ourselves to the elevated atmosphere; (b) interest rates are unlikely to rocket higher; and (c) because our forecasted earnings growth will bring valuation measurements down.

Say what you will about George Bush, but he’s been very user-friendly for stock market investors. The benefits from lower capital gains taxes and the reduction in the taxation of qualified stock dividends are huge. Many claim that housing prices have soared over the past several years due to the bursting of the Wall Street bubble and the decline in mortgage rates. Perhaps, but MBI would point out that home prices started to accelerate shortly after most capital gains taxes on personal residences were eliminated.

In general, MBI remains positive in our outlook for stocks over the next six to twelve months. But you would be disappointed if we didn’t rattle off a slew of caveat emptors. Here they are:

• The recent outperformance of smaller, lower quality stocks is more reminiscent of stock market tops than the beginnings of bull markets.
• The return of "market timing" is disconcerting: MBI believes that investors need to be opportunistic but we’re convinced that market timing is a fool’s game, even if you call it "tactical asset allocation."
• Insider selling currently dwarfs insider buying by multiples of more normal rates.
• Everybody and his brother are back into the tech, often using the same names as last go-around. Tech valuations are almost as "cuckoo" now as during the bubble.
• Hedge fund operators, having underperformed their benchmarks by being too much on the short side of the market, are covering their shots and going long. This helps in the shorter term, but isn’t too promising for the longer term.

MBI continues to be impressed by how little ground the market has given back after its initial rally. The market was giving some of its gains back during the second half of September. We’ll see how it does during the seasonally weak month of October. Investors seem to be at least paying lip service to buying more solid companies’ stocks, but we imagine this will pass quickly if the NASDAQ starts to outperform as it did earlier in the current rally. We will continue to take advantage of buying opportunities that all of this volatility creates, but will maintain our buy (and sell) disciplines. Throwing caution to the wind is seldom if ever a good idea. Fool me once, shame on you. Fool me twice, shame on me!

John E. Montgomery