Mid-Fourth Quarter, 2003
Investment Outlook Update
November 13, 2003

"If the Elections Were Held Today…"

With less than a year until the 2004 Presidential elections, several clients have called concerned about the effects on the stock market should George W. Bush fail to get reelected. Apparently, they had seen a recent poll which showed Bush losing to an unnamed Democratic challenger. We tell them to "relax." W’s chances of success are very high. The Democrats will have to name someone to run against Bush and therein lies the rub. Much like his predecessor, Bill Clinton, Bush is blessed with weak competition. Say what you will about Clinton, he was a charismatic politician running for reelection during a booming economy. And, boy, was he lucky!

W. is not all that charismatic but he is likely to get lucky on the economy. (More on that later.) Bush’s achilles heel is Iraq, but we expect that as election day approaches, Bush’s proxies in the press and the talk-show media will increasingly get out the party line that "while it’s awful to have American servicemen and women and (to a lesser extent) Iraqis being killed in Baghdad, it’s nowhere near as bad as having American civilians being killed in Washington DC, New York City, or elsewhere in the United States." I.E. Bush moved the "front" of the War on Terrorism to the Middle East.

But, President Bush’s real ace-in-the-hole is the field of Democratic presidential candidates. In his recent Wall Street Journal OpEd piece entitled George Bush vs. the Naïve Nine, retiring Democratic Senator Zell Miller stated

A month before the preliminary 3Q GDP was announced the National Association of Business Economists (consensus) was predicting 4.5% economic growth for the quarter. GDP was announced at 7.2%. To paraphrase baseball announcer Bob Euker, the consensus was "just a little low." Following the announcement, economists were generally described as being surprised but economists seem to spend a lot of their time being surprised. If instead of analyzing all the backward looking and constantly revised economic data and instead of paying any attention to the gloomsters in the media, you had simply watched the stock market, you would have been less surprised at the robust economic growth witnessed during the third quarter than were most economists.

MBI had predicted that, since an awful lot of monetary and fiscal stimulus had been pumped into the economy, and since we doubted that "this time it’s different," the economy was likely to rebound sharply. 3Q03 saw the fastest rate of economic growth in over 20 years. So, one does not have to go very far out on the forecasting limb to call for a slowdown in the rate of economic growth for 4Q03 and for 2004. Shown below is a chart of recent quarterly GDP growth at annualized rates.

The 30-year real growth rate of GDP has averaged 3.1%. MBI continues to believe that economic growth will surpass this for the next several quarters. The aforementioned monetary and fiscal stimulus continues to course through the economy. Consumers are feeling better because they have more disposable income and since their investments, especially stocks, have been appreciating. If factory orders are any indication, business spending looks to be on the mend. Inventories, which actually subtracted from 3Q economic growth, will need to be rebuilt eventually. Government spending will continue (always a safe bet, especially in a presidential election year) to expand. Foreign economies even look to be improving. (The trade deficit actually helped economic growth during the third quarter.) And, by golly, in spite of the unrelenting media gloom, employment actually increased in each of the months of a third quarter. How surprising!

MBI expects more of the same only less so.

Once upon a time, the Federal Reserve, much like the Wizard of Oz, stayed behind the curtain and forced the markets try to decipher its Delphic moves and statements. Now, in a triumph of form over substance, the Fed seems more concerned with its message than with its policies.

At its most recent meeting, the Federal Open Market Committee left the Fed Funds rate unchanged at 1%, a 45-year low. More importantly, as "they" say, the Fed affirmed its commitment to maintain low interest rates "for a considerable period of time." Websters dictionary defines "considerable" to be (1) significant or (2) large in extent or degree. MBI defines "considerable" as "too long." With economic growth clearly on the mend, with leading inflation indicators such as the money supply expanding rapidly, the price of gold (and other commodities) rising and the dollar under downward pressure, the Fed’s gung-ho monetary policy will spook the financial markets sooner or (more likely) later.

MBI just can’t bring itself to buy long bonds, in spite of record-low money market rates of return. Warren Buffett recently told Barrons that he isn’t enamored of Treasury bonds or junk debt. We concur. But with money market funds yielding around 0.5% per annum, it’s hard to keep bond allocation very short. Selected callable agencies, intermediate maturity investment quality corporate bonds and selected general obligation municipal bonds are our luke-warm recommendations. But we’d really prefer to stay short.

An alternative, albeit higher risk, income strategy is to take advantage of the new 15% tax rate for qualified common stock dividends by investing in the equities of companies paying higher yielding, well-covered, growing dividends. Which brings us to our…

… which is cautiously optimistic. In the same Barrons’ article, Buffett said that he’s "not finding anything" to buy in the stock market. While we kinda agree with him, MBI points out that Buffett increasingly buys all of larger companies and, therefore, has to pay a premium. MBI doesn’t have to play that game. MBI’s clients have the option of buying into smaller companies and we have never even considered buying all of any company. And, MBI never wants to pay a premium for any stock that we buy for our clients, or for ourselves. That said, we are not finding much of interest to buy in the stock market either, but we do like what we already own.

This is ironic since we are constructive on the outlook for the Stock Market for the next several quarters. In MBI’s opinion, we are in the sweet spot of a liquidity driven market. With the Fed’s policy of keeping interest rates low for a "considerable period of time," investors are faced with earning less than 1% on money market instruments, buying bonds with a questionable near-term interest rate outlook, or going into the stock market. Earning 1% on money market returns is acceptable when the stock market is going down but far less appealing when the stock market is returning over 23%, as the S&P 500 did from late March to mid-November of this year.

MBI believes that the wind is to the Stock Market investors’ backs. The economy is expanding, corporate profits are on the upswing, liquidity is moving into equities, and the stock market’s technical underpinnings are strong. Even though the proverbial Wall of Worry remains, it seems less high than it did just six months ago. Investors, flush with recently positive returns, have turned wildly bullish. Smaller and lower quality companies have been in the vanguard of this bull market and "tech" has been king. The chart below shows how various stock market indices have performed since the stock market bottomed in early October of last year.

As you can see the tech-heavy NASDAQ (COMPQ) and the small cap Russell 2000 (RUTZ) have considerably outperformed the S&P 500 (SPX). Additionally, we recently screened our database to show how larger capitalization, blue chip stocks have performed relative to smaller capitalization, lower quality stocks and compared to the S&P 500 over the past twelve and three month periods ending 11/12/03. The data is shown below:

More importantly, higher quality and larger companies are, in many cases, selling at lower valuations than the S&P 500 or than their lower-quality, smaller counterparts. MBI believes that rather than chase momentum, investors should concentrate on buying quality companies, especially when quality can be bought at a discount. Companies such as AIG, Cardinal Health, Pfizer and Suncor Energy look attractive to us at current prices. But smaller companies need not be ignored just because they are small. Higher quality smaller companies with good prospects and reasonable valuations which MBI currently finds interesting include Arch Capital, Lab Corp of America, Sunrise Senior Living and Trex, especially on any price pullbacks.

In spite of a fairly impressive rally since the market bottomed in October of 2002, this bull market has lagged prior bull market upmoves. Based on a study done by Leuthold Weeden Capital Management, the stock market, as measured by the S&P 500, could rally by another 20% during the second year of the current bull market. Include us in for the ride!

November 13, 2003         John E. Montgomery

Some charts courtesy of Baseline