The opening game for Major League Baseball this year was held in Tokyo. Talk about outsourcing! The Yankees lost to the Tampa Bay Devil Rays 8 to 3, but Yankee left-fielder Hideki Matsui hit a double in the first inning.

Baseball is considered to be the national pastime in the United States but since there is no professional team in our national capital, Washington, DC has adopted the "blame game" and its companion, "second guessing," as its favorite sports. In Washington, rather than "Play ball," we hear "What did you know and when did you know it?" Nowhere is this more evident than with the 9/11 Commission. We have been witnessing quite a spectacle in Richard Clark (we liked the Dick of American Bandstand better) selling his books by preaching that Bush should have done more to prevent terrorism. It is self-evident that everybody could have done more (or less) about almost anything… in retrospect. But the idea that we could have dropped Tom Cruise and the Mission Impossible team into Afghanistan and taken out Osama is pretty farfetched… even in retrospect. If only Mo had pinch-hit for Joe, we certainly would have won the game.

Between the 9/11 hubbub and the outsourcing noise, Bush’s reelection has become less of a "sure thing." At the beginning of the year, Howard Dean was the preemptive favorite to be the Democratic candidate for the presidency. But he took a shellacking in the early innings (primaries) as the ABB (Anybody But Bush) contingent took over the Democratic team. Now John Kerry will be the starting pitcher (presumptive nominee) for the Dems and many of the Republican fans fear that the game will be closer than they believed earlier in the season.

Currently, both the Republicans and Democrats are shoring up their core bases but we believe that the presidential election will be decided, once again, by that slim wedge in the middle of the political spectrum. Do you really believe that any liberal will vote for Bush regardless of how much better he might be than Kerry on national defense issues? Or, do you think that any conservative would vote for Kerry believing that Bush didn’t adequately hold the line on government spending? Both the baseball and political season are long and the pennant races are far from over.

When baseball players perform above their potential because they’re hyped on steroids, it’s a national scandal and elicits calls for political action. When the economy performs above its potential because it’s hyped on steroids, it’s called monetary and fiscal stimulus and elicits pleas for more action. We have yet to see the definitive study on the problems caused by the bubble economy and stock market of the late twentieth century but feel that there were even greater dislocations than currently believed. Two of the major problems facing the economy today—a shortage of capital spending and below-average job creation—are a result of the excesses of that period.

Far too much capacity was added during the period of easy money in the late 1990s and the early 2000s. Additionally, the number of workers hired and their costs rose while the quality of those employed often declined. The economy entered the new millennium with excessive capacity and employment. When the economic tide turned, getting rid of excess capacity and employees became a priority, and reversing course takes time.

No one can blame the American consumers for not doing their part. Strengthened by tax cuts and fortified by low interest rates, consumers have spent well into "extra innings." But relief is in sight. Corporate profits are now strong, inventories are now low, orders are now increasing, and capacity utilization is now rising. Additionally, new unemployment claims are down, help-wanted advertising is up, and surveys indicate increased hiring plans.

In our opinion, the economy is doing fine. Economists’ forecasts are starting to catch up with the stock market’s forecast and with reality, and their forecasts are now rising. Shown below is the last three years’ worth of quarterly GDP growth data plus the consensus forecast for the next four quarters.

Economic growth for 2004 is expected to be 4.6% and 3.8% in 2005. The press is not very good at covering economic matters and, besides, why let the facts get in the way of a good story. Politicians, similarly, are always willing to dismiss the data in order to demagogue an issue (really!), and this is especially so in an election year. Kerry needs to look like he’s got a plan, not to mention a clue. "W" should tell everyone to relax, but he remembers what happened to his father when he tried that twelve years ago. Even though the economy had already started the longest economic expansion on record, Bush (the elder) was sent to the showers by the electorate for looking like he had no clue, let alone a plan. MBI continues to expect the economic surprises to be to the upside.

We’re getting into the late innings of the Federal Reserve’s stimulative monetary policy game. So far the game has gone very well and the Fed’s monetary stimulus, combined with the government’s fiscal stimulus, has carried the day. Household wealth, based on the increase in housing values and stock prices, is at record levels surpassing the previous highs reached at the end of the first quarter of 2000. This increase in wealth has helped to spur consumer spending and, MBI believes, has gotten us to the point where corporate spending and new hiring should pick up the ball. But the fiscal stimulus is wearing off and the budget deficit is starting to cause consternation, if not actual harm, to the economy. Additionally, monetary stimulus is starting to leak into the price of things other than assets.

Members of the Fed have been throwing brush back pitches warning everyone that at some point rates will have to be increased. We don’t think that the Fed is in any rush but it is almost inevitable that interest rates will be going up. Shown below is a 5-year chart of the U.S. Treasury 10-year bond yield.

As you can see, its yield peaked in early 2000, well before the economy. The downward spike in rates that occurred in mid-2003 coincided with the Fed’s warnings of "deflation." (MBI didn’t swing at that wild pitch.) Interest rates subsequently spiked back up when the Fed first started making noise about eventually having to raise rates. The Fed quickly backed off this stance and interest rates subsequently settled back into a trading range. (As you might recall, MBI believes that the economy often works directly with interest rates. When rates go up economic activity increases and vice versa. We point out the 8% rate of GDP growth during the third quarter that coincided with the mid-2003 spike in rates.)

To date corporate borrowing has not been expanding but consumer and government borrowing remains robust, albeit at a decelerating rate. We are two years into the current economic recovery and, as you can see from the charts below, the prices of many things are rising.

We keep hearing that inflation is dormant even though housing prices and local real estate taxes, educational costs, health care expenses, and a myriad of other products and services which most of us use are going up.

The system is flush with liquidity and the Fed keeps telling us that it is in no rush to raise interest rates. The cost of being cautious and short term has been and continues to be costly since the yield curve remains steep, as shown below.

"Investors" look at money market funds yielding 0.5% versus the 3.9% yield on the 10-year Treasury Note and see owning longer maturities as a no-brainer. Hedge funds feel they have been given the green light to lever up with short-term borrowing in order to lend long and thereby magnify their "carry." Woe to them when rates start up!

A year ago we became cautious on bonds and the vast majority of investors is similarly cautious, if not flat-out bearish. It’s enough to make a contrarian bullish. Nevertheless, MBI continues to keep the majority of its clients’ bond holdings in high quality issues and short maturities.

Unlike in baseball where you can only speculate what might have happened if you had tried something else, in the stock market you always know exactly you should have done; no second guessing needed. During the first quarter you should have owned small-cap value stocks, preferably not on the NASDAQ. Now, wasn’t that easy?

After a quick start in January, the stock market got a case of the willies for most of the rest of the quarter. Prices for commodities, especially oil, started rising, bringing the sustainability of corporate profit growth and the durability of the economic expansion into question. Worries that John Kerry might actually defeat George Bush in November brought the prospects of increasing taxes and (even) more government spending. Outsourcing became a "red meat" issue. Protectionism is always bad for the global economy and for stock markets. Terrorists struck in Spain reminding us all of that continuing threat. It’s surprising that stocks didn’t do even worse given the high levels of bullishness with which the year started.

Presidential election years are almost always good for the stock market but you never know for sure. Expectations are a lot higher now than they were a year ago but so are stock prices, and, more importantly, valuations. Money keeps flowing into equity mutual funds, but the $69 billion of new dollars that went into equity mutual funds during January and February didn’t do much to lift stock prices. Corporate profits, however, have been and are expected to continue to be great. Forecasts are rising but not as fast as expectations. Montgomery Brothers is looking for a pitcher’s dual between the bulls and the bears for the remainder of the year, but we continue to look for 2004 to be an up year for stocks, in general.

We expect investors to shift their focus from small to large capitalization, from low quality to high, and from cyclically sensitive to more defensive growth equities. During 2003, the technology, materials, industrial, and consumer discretionary sectors of the economy outperformed. This year MBI expects the energy, financial, and health care sectors to do best. This would be also consistent with the historic precedence of past presidential election years.

If one uses the current yield on the 10-year U.S. Treasury as a benchmark (much like the mythical Fed model) the S&P 500 is around 10% undervalued. If, however, you don’t believe in the Fed model and/or that interest rates will rise, stocks are fairly to somewhat overvalued.

There’s a lot of time left in the year, the baseball season, and before the elections. While we expect a lot of faux excitement, we believe that the rest of 2004 will be more of a grind than a thrill. However, we continue to believe that stocks will return 6% to 10% for the year, that Bush will be reelected, and that your favorite team will win the World Series.

April 1, 2004
(the national holiday for stock market forecasters)

John E. Montgomery

Some charts courtesy of Baseline.