Montgomery Brothers, Inc. is not sure who will win this presidential election, but we are fairly certain the American people will be the losers. With so many important issues facing the country, a rational debate on the issues by the presidential candidates would seem in order. But NO! Negative campaigning and personal attacks are the order of the day. With Bush rising in the polls since the Republican convention, Kerry has juggled his campaign staff and resorted to adopting the same negative tactics. And why not? They work. While Bush vs. Kerry has not sunk to the lows of Burr vs. Hamilton, this is the ugliest presidential campaign we can remember.

We had been cautiously optimistic that the presidential debates would elevate the political discourse. But, alas, if the first debate was any indication, this is not to be. The debate reminded me of when I was in college. All too often, I would find myself with a twenty-page paper due but only five pages of material. I hoped that the professor wouldn’t notice that I’d just reworded the same information several times. But they always did. Our presidential candidates seem to confuse a consistent message with redundancy. Watching two "to the manor born," Skull and Bone Yalies hurl mud and brickbats at each other while dancing around the issues would be amusing, if it weren’t so discouraging. Two more debates to go! We can only hope things will improve.

We were surprised to read the other day that more than three quarters of probable Bush voters say their votes would be pro-Bush, not anti-Kerry. We were less surprised that 51% of Kerry voters say their votes are anti-Bush, and only 36% say their votes are pro-Kerry. Of all voters, 68% say that Bush and Cheney have a clear message as to what they will do if reelected. Only 36% say the same of Kerry and Edwards. Not surprising given a Kerry quote we came across saying, "My campaign is about replacing doubt with hope, and replacing fear with security." Hmmm! Sounds expensive. But, probably no more expensive than what we’ve witnessed during Bush’s first term.

Meanwhile, Wall Street continues to (generally) support Bush and believes him to be the odds-in-favor for reelection. But, as the saying goes, "don’t wish too hard, you may get what you want." Not only is Bush the first president since Hoover to see a decline in the number of people employed during his term, he is also the first president to see a decline in the stock market from the time he was elected to a month before the following presidential election since FDR’s second term. In spite of oodles of data to the contrary, stock investors continue to believe that the (re)election of a Republican for president is better for the stock market than electing a Democrat.

From our perch, Montgomery Brothers, Inc. senses that, while the electorate would like to fire Bush as president, they are unwilling to hire Kerry to be his replacement. Regardless, we expect a stock market rally after the election, largely because this sorry campaign will, at last, be behind us.

In spite of Alan Greenspan’s comments to the contrary, the recent (current?) economic "soft patch" seems to be continuing. The U.S. economic recovery is now in its eleventh quarter of expansion. While the average post World War II expansion has lasted nearly five years, the more recent recoveries have averaged closer to a decade. The lackluster stock market and the unexpected surge in energy prices indicate to us that economic growth might continue at what all too many consider to be unacceptably low rates. Nevertheless, Montgomery Brothers, Inc. expects that economic growth will continue at close to, if not slightly above, its 40-year average growth rate of approximately 3.3%.

The most recent revision to second quarter 2004 GDP shows that the economy grew at 3.3% for the quarter and at 4.8% for the past 12 months. Additionally, in spite of the growing chorus of "inflation is back," the core GDP deflator remains quite low at 1.7%. (See chart below for some historic perspectives.)

In spite of the Fed raising short-term rates, longer-term rates have actually declined recently. While many point to the flattening of the yield curve (see chart below) as an indicator of slowing growth, it is just as likely to indicate that inflation might not be as worrisome as many are now expecting. We’d also point out that, in spite of the flattening, the yield curve is roughly twice as steep as its historic average.

Job growth is less than robust and incomes are growing slowly. Higher energy prices will slow consumer spending but less than in previous cycles and, probably, less than expected. While every oil price spike since 1970 has been followed by a recession, the increased energy efficiency of the U.S. economy makes this less likely than in the past. Corporations continue to sit on piles of cash. Inventory control remains a corporate mantra, and recent surveys show that corporate spending plans are decelerating. Record budget deficits preclude, or at least ought to, further fiscal policy stimulus. Lastly, export growth is likely to slow as do global economies (China being a prime example) while imports should expand if for no other reason than we’re paying more for foreign oil. The usual economic naysayers are out in force, but this economic expansion, while not robust, is far from over.

We at Montgomery Brothers fancy ourselves as investment contrarians, but we feel you should have a good rationale for believing the consensus is wrong. For the bond market in 2004 such rationale was not necessary; the sheer magnitude of the consensus forecast that interest rates would be rising was overwhelming and all you needed to know. Even though short-term rates have increased, longer-term rates have declined. The returns from bonds, in general, have outperformed stocks this year. The Lipper Mutual Fund data shows that so far in 2004 (through 9/30) the average taxable bond mutual fund has returned approximately 2.9% while the average equity mutual fund has gained less than 1%. More than 80% of bond mutual funds are underperforming their benchmarks so far this year, even worse than equity funds.

Additionally, bond managers remain very negative on bonds. We believe this is due to the realization that the Fed has "crossed the Rubicon" and will continue to raise its targeted rates virtually regardless of economic growth and/or inflation. The Fed is likely to raise its Fed Fund rate to a more neutral position which indicates short-term interest rates in the 3% area, at a minimum. The Fed’s previously loose monetary policy not only led to extraordinarily low interest rates but also increased inflationary concerns. Now that the Fed is moving to reverse its earlier excessive ease, longer-term interest rates seem to be giving the Fed a vote of confidence by declining. Unfortunately, many are reading this decline in interest rates as an indication of a serious slowdown in the economic expansion. Who knows? Maybe the Fed is actually getting it right this time.

Unfortunately, when we look at the long-term economic and political fundamentals, we are forced to be less sanguine on the outlook for interest rates. Additionally, any examination of the long-term technical indicators, leads us to conclude that longer-term interest rates will eventually follow short-term interest rates higher. So… as much as we’d still like to make that contrarian "bet" on bonds, we just can’t.

There’s an old adage on Wall Street that you should "never sell a dull market short." Not only has the stock market been dull, its been wildly frustrating. On the surface, volatility has declined. For instance, during the first nine months of 2003, there were 14 days when the S&P 500 was up or down 2%. So far this year, none. But under the surface, there is plenty of individual stock volatility. Even though the S&P 500 has risen by only 0.24% during the first three quarters, over 1,100 stocks (in our 13,400 stock database) have declined or risen by 25% or more so far this year.

In spite of weakness in the Dow Jones Industrials, both the Transportation and Utility averages hit recovery highs in late September. Our New York Stock Exchange advance decline line hit a recovery high on September 30^th in spite of the recent weakness in most stock averages.

Shown below is a chart of the S&P 500 so far this year along with its 200 day moving average.

It shows a distressing series of lower highs and lower lows and a flattening of its moving average. However, MBI’s valuation models indicate that the fair market value for the S&P 500 is currently 15–20% above its current price. But most of us choose to buy individual stocks and, unfortunately, the pickings (like the presidential choices) are slim.

With the election upon us, politicians look to the market, and vice versa, for direction. In fact, the election has become a new obsession among investors. We’re told that when the Dow Jones Industrials increased by 3.3% or more in the month before the presidential election, the incumbent party never lost the White House; and, if the Dow has declined by more than 0.5%, the incumbent party has never won reelection. We wonder if this is causal, coincidental, or circular. Bush remains very popular with stock market investors. But why? Since 1945, the S&P has risen, on average, 10.7% under Democratic presidents but only 7.6% under Republicans.

Our long awaited rebound in large capitalization, blue chip stocks remains illusive but MBI’s commitment to higher paying dividend stocks has been working. The Energy sector has outperformed the stock market which is not surprising given the increase in oil prices, but most energy company shares have underperformed the price of crude oil itself. The Information Technology sector has greatly underperformed the S&P 500 and done even worse than the NASDAQ Composite’s 5.3% YTD decline. While we believe that we may see a reversal of these trends over the near term, we feel that both trends are long term.

Thankfully, the uncertainty of the presidential election will soon be over. So watch the debates if you can stand it, then go out and vote. If you think your vote doesn’t count, there must be someone whose opinion you hold in such low esteem that you need to offset his or her vote. And besides, if you don’t vote, you shouldn’t be allowed to whine about the outcome.

October 1, 2004
John E. Montgomery

Some charts courtesy of Baseline and Briefing.com