I promised myself that I wouldn’t do it and, even as I did, my daughter, Julia, told me that I’d be sorry. Nevertheless, I plunked down $9.25 recently to see Fahrenheit 9/11. I am sure that I’ve wasted larger amounts of money in even more worthless endeavors, but none comes to mind. Michael Moore’s "Documentary film" on the events surrounding the September 11, 2001 attack on the United States is to documentaries what reality TV is to reality. Why let the facts get in the way of a good story?

Most people entered the theater with their minds already made up. The ABB (anybody-but-Bush) contingent was obviously (to me, at any rate) in the majority, and were ready to whoop it up at every dig on "W". The rest of us sat there in stony silence wishing that we had heeded our earlier inclinations to skip this. It is doubtful that Moore’s flick could change even the feeblest of minds and will probably (mercifully?) have no effect on the outcome of the election. If Michael Moore has become an important spokesman for the liberals of this country, God help the liberal cause!

Most polls continue to show the Presidential election as too close to call. Kerry (and Edwards) got very little in the way of a "bounce" coming out of the Democratic Convention which contained about as much as suspense as a professional wrestling match. Next up is the Republican Convention in NYC. Who says there’s nothing to watch T.V.?

One of the myriad of things bugging the stock markets is the Presidential election. At the beginning of 2004, it looked like George Bush would have an easy go at it with Howard Dean. (Remember him? He’s now debating Ralph Nader on PBS. Aiiii! How the mighty have fallen!) Even though, statistically, Democratic presidents provide better returns than Republicans, the "stock market" seems to prefer Republican presidents. Other things bugging investors are the economy (more on this below) and Iraq. Many expected that the latter might fade as a concern but, unfortunately, it has not. At least the presidential election will be resolved by November 2^nd. Maybe!

As Julia and I walked out of the theater after watching Farenheit 9/11, I said to her that I couldn’t believe that the French had awarded it the Palme d’Or at the Cannes Film Festival. She reminded me that the French consider Jerry Lewis to be a comic genius.

Another thing bugging the stock market is, of course, as always, the economy. 2004 started with general expectations for continued robust expansion and with the "consensus" forecast being increased. The Federal Reserve was warning us that, by golly, sooner or later, ready or not, interest rates would have to go up at some point in the foreseeable future. But, of course, at a moderate pace. At the end of June, the Fed made its initial tightening move.

Now, suddenly, we’re in a "soft patch" of economic growth and the consensus forecast is being reduced. One of the culprits is $45 per barrel oil that, in spite of global expansion and the Iraqi war, no one predicted. At $20 per barrel, oil was going to $15. At $30, it was going to $20. But now at $45, it’s going to $60. Once again, the experts are surprised. MBI has always felt that the greatest value of consensus forecasts is that at least there was one thing that you can guarantee won’t happen.

Increasing energy prices negatively impact economic growth since consumers have a little less to spend on other things. MBI doesn’t worry too much about consumer spending going off a cliff. We believe that consumers will continue to spend roughly every cent that they make after taxes (if not more). While they might pull in their horns for a month or two, the idea that American consumers will suddenly become frugal has no historic precedent. Living beyond one’s means is the American Way. Look at the Federal government. So, in spite of the requisite amount of economic handwringing, we expect that the economic expansion will continue along at its 30-year average growth rate of 3%, sometimes slower, sometimes faster.

The fiscal stimulus of deficit spending has started to ebb, but lower tax rates continue to give consumers the ability to spend. Additionally, corporate profits, in spite of the lousy stock market action, remain strong. Inventory rebuilding and capital spending should continue to increase in spite of the current chicken little, code orange mindset pushed by the press. And if corporations don’t spend their profits, they will probably pay out higher dividends that would also be good for the economy.

The ultimate day of reckoning is far, far into the future, although closer than yesterday, and closer than any mainstream politician would ever tell us. But, preparing for Armageddon is just a little premature!

In our Second Half 2004 Outlook, we mentioned that if there ever was a consensus to bet against, it was that interest rates would rise. Shown below is the yield curve Tuesday, August 17^th and three months earlier.

At the beginning of the year, interest rates were going to rise since the economy was so strong. Now, interest rates are going to rise because inflation will be higher than expected. But wait! Inflation has already been higher than forecasted and all except the shortest term interest rates have seen their yields decline, as you can see from the data below!

MBI does not believe that markets are always right but we do believe that they are fairly efficient, especially over the longer term. Additionally, while we aren’t the biggest fans of activist monetary policy, we do believe that the Fed is unlikely to reverse field again anytime soon. The Fed is far from tight, but the currency, precious metals, and interest rate markets are unlikely to stand idly by, should the Fed abandon its long-term anti-inflation bias. While the "path of least resistance" for interest rates does appear to be upward, MBI usually prefers to bet against the consensus.

At the beginning of the year, corporate profits were forecast to be great. And corporate profits have been great! Unfortunately, while profits should continue to be terrific, momentum appears to have peaked in the face of extremely high expectations. Not a good thing for stock prices.

Investment returns have been disappointing so far in 2004, with the average U.S. bond fund returning 1.65% and the average U.S. stock fund losing 5.7% (through August 12^th). As a result, investor sentiment has soured and money flows into mutual funds have slowed to a trickle. Chart patterns are looking pretty awful and there is increasing chatter that the "Bull Market" of 2003 was actually a rally in a Secular Bear Market. If investors get any more gloomy, we’ll have no choice except to get bullish but, in general, we remain pretty neutral towards the market.

Stock prices, on average, are now sporting decent, but not great, valuations. Shown on the next page is our Baseline "Best Fit" for the S&P 500 using the past twenty years’ worth of data. Also shown is the trailing price earnings multiple, the dividend yield, the price to cash flow ratio, and the price to sales ratio based upon the past twenty years of historical data.

 
Decent but not great! Unfortunately, in spite of some pretty grizzly carnage, for an awful lot of stocks, we find it difficult to find stocks that we can get very excited about buying. We believe that we are way overdue for a rally but feel that stock prices are heading nowhere fast until after the elections. Nevertheless, with the economic outlook decent and stock valuations reasonable we believe that the longer term "path of least resistance" is up.

Farenheit 9/11 is scheduled to be on Cable TV fairly soon. Do yourself a favor – skip it!

John E. Montgomery

August 18, 2004