MONTGOMERY BROTHERS

I woke up early on the morning of November 2^nd ready to do my civic duty and vote. But, faced with long lines, I decided to head down to the D.C. Superior Court Building to do my civic duty and serve my “one day or one trial” jury duty. I fully expected, as when previously called, to be dismissed after one day. I sat through voir dire (which is French for “spending far too much time accomplishing far too little”) only to find that a jury couldn’t be selected in “one day” and I’d have to return on Wednesday. Dejected, I headed back to the polls to exercise the ultimate in civic duty futility – vote Republican in the District of Columbia.

While at least 54 million fellow citizens were disappointed at the outcome, most Americans were relieved that the Presidential election had been decided by late Wednesday morning. Even though far from decisive, Bush did win the majority of the popular and Electoral College vote, a feat not accomplished since 1988. Additionally, Republicans expanded their control of both the House and Senate. With the exception of Tom Daschle, Phil Crane and a couple of Texas Democrats who were forced to face other Republican incumbents through redistricting, incumbents ran the election table.

Even though Bush claimed a mandate, Montgomery Brothers doubts much will change. Second term, dare we say lame duck, presidents seldom accomplish much. The country is still divided and, while Democrats will fear being “Daschled”, it’s doubtful that they will play ball with “W”. We’ll get an early glimpse at any “new bipartisanship” in the lame duck session of Congress. One of the issues to be addressed is the Federal debt ceiling which no one wanted to deal with prior to the election. Instead, with the government bumping up against its debt limits, the Treasury was forced to use accounting gimmicks to finesse its borrowing. If a private sector company used such techniques it would be charged with accounting fraud. But, as we know all too well, the Federal government doesn’t have to play by the same rules that it imposes on the rest of us.

President Bush wants to pursue an aggressive policy to achieve his goals and is urging bipartisanship and cooperation, or else! Bush intends to make his tax cuts permanent while simplifying the tax code; to reform social security; to increase energy independence; to give tax incentives in order to spur health care coverage while reducing costs; and, to incent greater savings and retirement investment. All while cutting the budget deficit in half. It would be nice!

By the way, after a day and a half of voir dire and two and a half days on a jury, I was dismissed. I had been an “alternate.”

Economic Outlook

It is usually difficult to unseat an incumbent president during and economic expansion, and 2004 proved no exception. Regardless of the facts, the economy is thought to be in poor shape and the press was quick to write articles explaining what Bush should do to get the economy reenergized. The current expansion started in November 2001 and has been growing at an annual rate of 3.3% since. Third quarter GDP growth has been preliminarily reported at a supposedly “disappointing” 3.7% annual rate, even though this is above the 40 year average rate of GDP growth and above the 3.3% rate of the second quarter. Third quarter GDP growth was better balanced than second quarter and less reliant on the inventory accumulation of earlier periods. In spite of the recent “soft patch” in some data, the year to date economic numbers are pretty impressive. Even the employment situation is less dire than advertised with the unemployment rate, at 5.5%, nearly a half a percentage point below its 40 year average.

The doomsters point to persistent budget deficits, U.S. dependence on imported oil, U.S. reliance on foreign borrowing to fund our trade deficit (is that redundant?) and rising health care costs as long term problems that should be addressed, immediately. They’ve been pointing out these imminent dangers for quite some time.

In spite of the rise in oil prices, inflation remains contained and has actually decelerated, recently. In spite of the Fed raising short term rates, longer term rates actually have declined from late second quarter levels. In spite of high debt levels, consumers continue to spend. And, in spite of all of the dire warnings, the economy moves ahead.

While MBI believes that Bush will pursue many of the economic policies he discussed during the campaign and possibly even achieve a few victories, we expect little change in the current economic environment – steady as she goes.

Interest Rate Outlook

Bush has been very, very good for bonds. Since he was elected four years ago, the annual total return from the Lehman Bond Aggregate has been 7.7%. During the same time, the annual total return from the S&P 500 has been (4.2%). Historically, the first year after the reelection of a Republican president has been better for bonds than for stocks. We wouldn’t put too much weight on this latter observation due to the limited number of observations and since this type of analysis is closer to trivia than analysis.

Meanwhile, when I grow up I want to be as brave as Alan Greenspan. Hedge funds don’t scare him nor does $50 per barrel of oil, nor derivatives, nor the housing bubble, nor the level of consumer debt. Probably not even the big bad wolf. Dr. Pangloss was a bigger worrier! Regardless, the Fed just raised short term rates again and probably will again in December. Even though the Fed funds rate has doubled, real interest rates remain quite low. MBI continues to see monetary policy as expansionary and points to the (once again) weakening dollar and the (once again) rising price of gold as evidence.

Many are arguing that a weak economy and low inflation warrant an end to the Fed’s policy of raising rates. The Fed’s own model says that each $10 increase in the price of a barrel of oil results in a 0.4% decline in annual GDP growth and a 0.2% increase in the annual rate of inflation. (Oil is up nearly $30 per barrel during the past year.) MBI sees current supposedly “disappointing” economic growth continuing above its historic average and in excess of its estimated potential. We also see increasing tax revenues, a still steep yield curve, and the consistent strength of the Dow Jones Transportation Average as indicators of better than expected economic growth ahead. We keep hearing about all the awful things that the “Twin deficits” will cause. We’re near $500 billion for both and interest rates are still near 40 year lows. The Fed might take a short breather in raising rates but we see greater risks that interest rates will go up than possible reward from rates going down.

Stock Market Outlook

The stock market apparently got what it wanted with the President’s reelection. MBI, along with virtually everyone else, had been forecasting a “relief rally” once the election was over. While we hope that it develops into more, we’re doubtful. We’ve discussed before the propensity of performance crazed hedge and mutual fund managers to drive the market over shorter periods of time and the role that momentum plays in the markets. This is especially true during the fourth quarter when managers, whose bonuses depend on relative performance, run out of time to play “catch up ball”. Last year’s fourth quarter witnessed a 12.2% gain in the S&P 500. Certainly, at least some portion of that gain anticipated the great earnings which we’ve witnessed so far this year. But, it’s impossible to gauge, and really makes little difference, how much of that gain was due to momentum and how much was because of fundamentals.

While stocks have not done very well during Bush’s first term, it’s hard to argue that his polices haven’t been intended to be stock market friendly. Now that the election has been resolved, at least one uncertainty has been eliminated. Second term Bush policies should be beneficial to health care (more free market approach), energy (greater tax incentives and more drilling “rights”), brokers and money managers (pro savings policy and possible privatization of a portion of social security) and defense (continuing increases in spending) - at least according to conventional wisdom. (Dis)similarly, Bush policies are expected to be tough on GSE’s (more competition for Fannie and Freddie) and life insurers (who rely on annuities which might suffer reduced sales from increased savings incentives.) What MBI sees is that only the uncertainty of the election is behind us.

Little noted amidst the election hubbub was the 75^th anniversary of the “Crash” in October 1929. October is a notoriously lousy month for stocks even though September’s returns are statistically worse. So we were happy to get through the past two months relatively unscathed. We took a few nicks, but otherwise its been the same old, same old. Boring!, but not as boring as jury duty.

It is my intention to continue to vote in every election, but I’m in no rush to serve on another jury. Whoever said civic duty would be easy?

November 10, 2004
John E. Montgomery