Given the current controversy over gay marriage and the recent success of the cable television "Queer as Folk," is it any wonder that "The ‘L’ Word" is one of the most popular new shows on TV? We are far too politically correct "to go there" but "The ‘L’ Word" is such a clever segue to our mid-second quarter Investment Outlook that we just couldn’t pass it up.

As you might be aware, 2004 is an election year. While one might think that with somewhere around 150 million potential presidential candidates out there, we’d get better candidates than these two, but that’s not our point. MBI is disappointed that we’re not getting much of a debate between the Democrats and Republicans as to the direction the U.S. should be going. Disappointed? YES! Surprised? NO!

Just when we thought that the level of political debate in this country could not get much lower, the politicians ratcheted it down another notch. So, instead of debate, it’s mostly name calling. "John Kerry is a Liberal". Perish the thought that voters might have to consider what liberal means; suffice it to say Kerry is a Liberal like Teddy (yikes!) or Hillary (worse!). "George Bush is a Liar." He’s not to be trusted since he’s leading the U.S. down the wrong path. Perish the thought that we have a debate over what is the correct path, Bush has lied to us about Iraq (yikes!) and the economy (worse!).

But wait, the economy is on the mend. The expansion is now 2 ½ years old during the past year ending 3/31/04; real GDP expanded 4.9%. This has been the fastest rate of expansion since 1984. But this expansion has been dubbed "a jobless recovery" at least until last Friday (5/3). So even though it was difficult to complain about the economy, we could worry about Labor. Now, suddenly, the "jobless recovery" has ended. While many blame slow (or no) job growth to high labor productivity, we feel there is more to the story. Among the excesses of the bubble economy was that many marginal workers became employed. How else would you explain how the U.S. economy got down to a 3.9% unemployment rate? Like every other economic excess, such as inventory and capacity, this needed to be worked off. When productivity is rising faster than the economy is expanding there is little need to increase employment but, with productivity growth slowing, employment is starting to expand. Now we’re left to wring our hands over the Loss of manufacturing jobs (usually labeled "high paying"). The manufacturing workforce has been declining for 40 years and yet manufacturing output continues to grow. Outsourcing has similarly been going on for years (both in the U.S. and other developed countries) and its pace hasn’t changed much either. These are part of the natural evolutionary economic process.

The U.S. economy is very dynamic and the flexibility and mobility of labor is among its strongest attributes. We have far greater confidence in the U.S. economy’s ability to create jobs than we do in the U.S. government’s ability to measure that job creation. One of our colleges recently quipped that the reason so many jobs get outsourced to India is that the Indian work force is well educated and speaks English. We should try that here!

At any rate, with the economic expansion on solid footing jobs are now being created at an annual pace of over 1 million based on the recent employment trends. If 2 million people were to be added to payrolls at the current average rate, $1 billion per week would be added to the consumer spending stream. And with weekly earnings up 2.5% year over year, those 138 million already employed are doing better too! Most of this increased income will go to spending but some goes to taxes too. That additional tax revenue along with higher corporate taxes should cause the Federal budget deficit to be as much as $100 billion less than was forecasted just six months ago. Corporate spending is also showing solid signs of growth.

MBI continues to expect the economic news to surprise to the upside.

As long as labor markets stayed weak the Fed could keep interest rates low. The combination of an expanding economy with rapidly rising corporate profits and little likelihood of the Fed raising rates created a near perfect environment for speculative "investing." The Fed lowered interest rates to near half century lows, then told us that rates would stay at such levels for a "considerable period of time," then that it could be "patient" in raising rates, and now says that rate increases, when they come, will be "measured."

For God’s sake, get on with it, raise rates and shut up! All of the uncertainty caused by all of the jawboning and preparing the market for the inevitable increase in interest rates is probably worse for the economy and financial markets than the actual act of raising rates will be. In addition to helping the economy, the Fed’s highly stimulative monetary policy has helped to cause excessive speculation in the financial markets. The Fed’s policies gave the green light to speculators to take on a great deal of risk, often on huge amounts of leverage. Investors of all stripes, but especially Mutual and Hedge Funds, have borrowed short to lend (or invest) long, often on heavy leverage. How this so called "Carry Trade" gets unwound is a real and present danger to the financial markets and, maybe, to the real economy. The lunacy of the Fed’s loose lips policy is that low rates and the steepness of the yield curve actually encourage the "Carry Trade" and the Fed’s effort to talk the market down looks like it’s been a loser so far.

Shown below is a chart showing the yield curve as of May 12^th and three months earlier.

The yield curve has steepened which encourages, rather than discourages, the "Carry Trade" speculation. There’s an old adage of Wall Street that "if you’re going to panic be the first to panic." Unfortunately, it is more likely that the majority will wait until the last moment then try to hit the exits simultaneously. Hopefully, the unraveling of the "Carry Trade" won’t get too ugly since the Fed has limited its options by having already exhausted most of them.

From an economic point of view, once the Fed starts raising rates (or, as we have seen over the past several months, had rates raised for it), economic activity often speeds up. If the Fed interprets faster economic activity as a reason to raise rates even more in order to slow the economy, then we could have some real economic problems in addition to the financial market willies we’ve recently been experiencing. MBI is constantly amazed at the faith that so many put in the Fed’s ability to control and forecast the economy. There have been only two, that is 2, recessions in the past twenty-five years. The Fed failed to forecast either. A year ago, the Fed was wringing its hands over the slow pace of the economic expansion and about the possibility of deflation. In the subsequent twelve months the economy has expanded at the fastest rate in twenty years and, so far in 2004, the core rate of inflation is 2.5x what is was during 2003.

MBI has been bearish on the bond market for over a year and we remain pretty stand-offish (that’s a sophisticated technical term on bonds). However, if the bond market continues to push interest rates higher bonds will eventually become attractive to us again. The longer the Fed waits, however, the uglier the situation is likely to get. So, Fed, get on with it!

Look out below! It seems like the stock market can take almost anything except prosperity. No sooner does the U.S. economy start to employ a couple of people in good paying jobs than the financial markets sense impending doom! So far, 2004 has proven to be a pretty lousy year. Responding to the great run-up in stocks during the last three quarters of 2003, and because 2004 is a presidential election year (usually good times for stock prices), investors entered the year in an ebullient mood. To date this year, over $100 billion has been added to equity mutual funds. And what do investors have to show for it? Through May 12, the S&P 500 is down 1%. Shown below is a chart showing how several of the major averages have performed so far this year.

Most major are down for the year. Get used to it. We expect that a trading range will continue at least until the election. And for the year? It all depends on what, if any, kind of post-election/Santa Claus rally we might have.

MBI has always felt that the two major drivers of stock prices are corporate profits and interest rates. Corporate profit growth has been great and, while likely to slow, should remain pretty darn terrific for several more quarters. Interest rates, however, have been rising and are likely to continue to rise. In the short run, rising interest rates are poison for stock prices. During the three most recent periods of rising interest rates the stock market declined in spite of impressive growth in corporate profits. Look for four in a row.

As interest rates rise, investors become less adventuresome. This is already being seen by how smaller capitalization, lower quality stocks have performed recently. Since the end of January the Russell 2000 and NASDAQ Composite are down around twice the percentage decline of the S&P 500. This trend should also continue.

The financial markets, especially the stock market, have become increasingly volatile over the past several decades while the economy has become less cyclical. Even with a stellar economic outlook, our forecast for stock prices is considerably more subdued. Defensive (consumer nondurables), healthcare, and energy related issues should outperform the cyclical, financial and consumer discretionary sectors. Net net, we expect 2004 to be a fairly lackluster year for stock prices, in general. But keep in mind, it’s when the majority is bearish that the best opportunities present themselves. Only six months until the presidential elections. What the "L"!

John E. Montgomery