It is the iron rule of elective politics: if you don’t win the election, you don’t get to do all those wonderful things for your supporters, or awful things to your opponents. All incumbent politicians work hard to get reelected, but we’re hard pressed to name anyone who holds a candle to George W. Bush in his single-minded pursuit of a second term. While anything is possible and there will be surprises along the way, Bush looks like a mortal lock for reelection in November, 2004. And, he’ll probably have coattails since it looks like Republicans will pick up seats in the House and the Senate.

Bush faces no Republican opposition for the presidential nomination in 2004, which allows him to concentrate on his job and the election. I—as f that’s not redundant! Virtually all presidential elections turn on pocketbook issues and, as you can see from the cartoon below, Bush "owns" these issues.

Additionally, the American jobs machine seems to be gearing up just in time for the 2004 election. And, with the capture of Saddam Hussein, the Bush administration is to have a plan in place before November to extricate US troops from Iraq.

This should leave the Democrats to run primarily on the issue of the budget deficit. We wish them luck! The Democratic party is generally viewed as "tax and spend liberals" beholden to special interest groups. But running on raising taxes, if history and recent state and local referendums are any indication, is a losing strategy. Most taxpayers would rather keep the money they earn than pay taxes! The Republican party, on the other hand, is increasingly viewed as cut-taxes-and-spend pragmatists who pay lip service to conservative special interest groups. It’s increasingly apparent that budget deficits are the concern of the minority party and important mostly inside the Beltway.

Like Bill Clinton before him, George Bush instills a lot of hatred in his opposition, but probably not anywhere near enough to cost him the election. In 1996, the Republicans ran the affable and capable (but ultimately unelectable) Bob Dole. In 2004, the Democrats are likely to run the irritable and probably unelectable Howard Dean. Then, Dean is likely to join the likes of Barry Goldwater, George McGovern, and Walter Mondale as politicians who were thrown on their party’s ideological presidential funeral pyre in some sort of symbolic gesture. The recently jilted Joe Lieberman said it best after Al Gore endorsed Dean:

Montgomery Brothers believes that the financial markets want, and more importantly, expect Bush to win the election in November. But as the old saying goes, "Be careful what you wish for; you might get what you want."

2003 started out badly enough with the country teetering on the brink of war, with anemic economic growth, with the Fed yapping about deflation, and with the stock market in the worst bear market since the Great Depression. Actually, the bear market had ended early in the fourth quarter, but the combination of potential war and corporate scandals along with the unrelenting gloom of the press snuffed out the fourth-quarter 2002 rally which, in retrospect, heralded the coming of better economic times.

At the beginning of 2002, Montgomery Brothers had all the right pieces of the economic puzzle—stimulative monetary policy, expansive fiscal policy, rising commodity prices, declining value of the dollar, presidential cycle—but we pieced them together and concluded that economic growth would remain slow and that inflation would speed up. Unfortunately for us, but fortunately for the country, just the opposite occurred: economic growth sped up and inflation remained low. That’s what we get for agreeing with the consensus and going with conventional wisdom.

Usually, Montgomery Brothers focuses on (a) where we believe we are in the economic cycle, (b) what the financial markets are telling us will probably happen, and (c) how the future is likely to deviate from the consensus outlook. Based on (a), Montgomery Brothers believes that we are right smack in the middle of the sweet spot of the expansion. Shown below are various indicators of economic growth.

As employment picks up, inventories are rebuilt and capital spending accelerates, the economic signals will strengthen further. Based on (b), above, the financial markets are similarly pointing to a rapidly expanding economy. Shown below is a chart of the appreciation of the Dow Jones Industrial Average, S&P 500 Index, Russell 2000, and NASDAQ Composite for the year ending 12/31/03. Following that is a chart showing the US Treasury yield curves for 12/31/02 and 12/31/03.

We find few examples of economic growth slowing, let alone tanking, after periods of strong stock market performance. Additionally, the yield curve is currently as steep, if not steeper, than last year at this time.

As we have said many times, Montgomery Brothers believes that gold is a leading indicator of inflation. But recently, work done by Ed Hyman and his colleagues at ISI Group indicates that the price of gold also correlates with nominal GDP growth. In the past, when inflation was higher, there was a large gap between nominal and real GDP growth, and the price of gold was a good indicator of inflation. More recently, with inflation low, the correlation between gold and nominal as well as real economic growth has been stronger. Unfortunately, it is only in retrospect that you know for sure but you have to make the call now. Shown below is a chart correlating the year over year price of gold to the year over year growth of real GDP.

Lastly, regarding (c), above, we show below the consensus forecasting of 60 economists as compiled for the Business Week Economic Survey. Below that is the Montgomery Brothers forecast.

Montgomery Brothers feels that economic growth will remain stronger than the consensus expects and that inflation will be slow to uptick. Corporations will continue to show above average earnings growth since they’ll be slow to increase hiring and borrowing. The downside is that all of the fiscal and monetary stimulus is borrowing from future growth, and should the economy not enter into a self-reinforcing growth pattern, the economy could grind to a halt in a hurry. But that’s a risk inherent in this presidential economic cycle.

In spite of abundant evidence to the contrary, many (if not most) observers believe that the Federal Reserve attempts to manipulate interest rates for political reasons. Always looking for scapegoats, politicians often blame the Fed for interest rate moves made, or more often not made, especially during election years. Nowhere is this more evident than the belief by many Republicans that the Alan Greenspan Fed’s tight monetary policies caused George H. W. Bush to lose to Bill Clinton in 1992. Possibly, no one believes this more than George W. Bush.

In spite of our belief that the Fed should move to raise interest rates sooner rather than later, we doubt this will happen. Why? Because the Fed has told us over and over again that the plan is to leave rates low for a "considerable period of time." In our opinion, the Fed is focusing on employment growth, bank lending, and nominal inflation indicators, especially the personal consumption expenditure deflator for guidance on when to raise rates. None have shown any significant increase, nor are they likely to soon. Corporations will drag their feet on hiring to keep profits expanding and most companies are still repaying and refinancing debt rather than increasing borrowing. Nominal inflation lags the economy by a long period of time. So long, in fact, that inflation is unlikely to become a problem until well after the elections. So MBI sees no interest rate increases any time soon.

Unfortunately, the monetary fuel for inflation is already in the pipeline. As long as inflation can be contained to the financial and housing markets, (almost) everyone will be happy. Rising prices for financial assets and homes make consumers feel better off and voters who feel better off propel the economy forward by spending and they vote for incumbents.

Montgomery Brothers is far from positive on the bond market outlook. While we expect that interest rates will rise, we expect them to do so later than most. But, if we’re wrong (which happens with distressing frequency), interest rates are likely to rise faster and farther than most might imagine and fear. At the initial phase of rising interest rates, economic activity usually accelerates as consumers and corporations borrow in anticipation of yet higher interest rates ahead. This, in turn, causes the Fed to raise rates more, which, in turn… You get the picture.

Our real fear is that the U.S. would go back to the type of boom/bust economic cycle that we have not witnessed for two decades. Given the amount of monetary and fiscal stimulus applied to get the economy going after the recent mild recession, we fear what the next desperate-to-get-(re)elected politician might do. But that’s a worry for another Investment Outlook.

Montgomery Brothers believes that bond investments should be concentrated in shorter maturity, investment quality bonds, or those whose interest rates adjust periodically to inflation, such as "TIPS." Lower quality bonds and developing country debt far outperformed higher quality issues in 2003. As the economic expansion ages and matures, the penchant for taking risks is likely to abate.

Equity investing is the only business that we’re aware of where the price of the merchandise needs to be substantially marked up in order to attract buyers. Even though the stock market had bottomed in October of 2002 (which we know due to our near perfect hindsight), stock investors entered 2003 in a decidedly dour mood. But now that the major market averages are up by 25% to 50%, investors feel much better about the outlook for stocks. In late 2002 and early 2003 stocks, in general, became reasonably valued but few investors were interested in buying them. Bonds and hedge funds (especially those that shorted stocks) had done well so that’s what attracted investors’ attention. Stocks are now back to overvalued levels but have done much better than bonds and most hedge funds, so that’s where investor attention is now focused.

As you can see from the chart on page 4, smaller cap and lower quality companies (indicated by the Russell 2000 and NASDAQ Composite) far outperformed larger cap, blue chips (indicated by the Dow Jones Industrials and the S&P 500). Like junk bonds, junk stocks did best in 2003. We keep hearing that "the easy money" has already been made, but in all the decades that we’ve been doing our investment "schtick," we’ve never made any easy money. At any rate, with the economic expansion now into its third year, with corporate profits having rebounded smartly, and with the "easy money" made by having bought junky little stocks during a raging bear market, it’s time to change one’s focus and strategies.

As the economic expansion and the bull market in stocks mature, investors often gravitate to companies whose earnings are more predictable. Often these are large capitalization, blue chip stocks—the exact type of companies and stocks that have lagged during this bull market. Additionally, on a relative basis, such stocks are considerably cheaper than their more speculative brethren. Unfortunately, very few stocks are cheap on an absolute basis. But this is a liquidity-driven market and with short-term interest rates at near half-century lows, and hundreds of billions of dollars parked in short-term instruments earning next to nothing (and less than nothing after taxes, inflation and fees), there’s plenty of liquidity to drive this market.

And, there are plenty of bears (actually, far fewer than a year ago) who still need to capitulate by turning bullish. Not to mention a lot of short sellers who must be feeling more than a bit uncomfortable in this market. If and when they cover their shorts and go long, even more demand for stocks will be generated. In spite of all of the scandals, investors have poured almost $140 billion into equity mutual funds so far in 2003. A triumph of greed over fear. The technical underpinnings of this market are impressive. Overbought conditions, and there have been many, have been followed up by short and shallow corrections. These corrections give little opportunity for the underinvested to "buy the dips." This is highly reminiscent of what was going on during the "bubble."

Additionally, it’s starting to dawn on investors what a good deal a 15% tax on most common stock dividends really is. Since this significant equity investor benefit was enacted, non-dividend paying stocks have outperformed those paying dividends. We expect this to reverse and believe that such a shift may have already started. Besides large cap blue chip, and dividend-paying stocks, we like the energy and health care sectors where we’re increasing our weightings. To pay for these investments, we are reducing our overweighting in financials. Lastly, there will always be a place in our hearts, not to mention in most of our clients’ portfolios, for well-reasoned and researched special situations, regardless of capitalization.

In closing, let’s not forget that 2004 is the fourth year of the presidential cycle. Since 1945, the final year of the four-year presidential term has, on average, shown the second best annual returns, surpassed only by the third year. (Hint, hint! 2003 was the third year in Dubya’s cycle.) See the chart below.

That’s the good news. The bad news is that most of such up-moves in stock prices occur during the first half of the fourth year of the presidential cycle. This could prove especially true given how much bad stuff (e.g., budget deficits, the dollar, protectionism) is being ignored by suddenly starry-eyed stock investors. Much of what is being ignored could start hitting the fan during the second half of 2004, but certainly will in 2005. (More on that later.)

2003 was the first "up" year for stocks in the twenty-first century. We’re expecting big things for the rest of this century, but currently are focused on 2004 which we expect will be a continuation of 2003 but writ small.

Happy New Year.

John E. Montgomery