Many years ago I made a New Year’s resolution which I’ve kept for all the successive years: no more New Year’s resolutions. But it’s time for a change. My New Year’s resolution for 2005 is to become—are you ready?—an optimist.

If, as many say, a pessimist is an optimist with experience, I’m already one of the most experienced optimists around. But what has gotten to me recently is the never-ending barrage of negatives bombarding us from all fronts. One would think that things were getting worse when they are undeniably getting better, both domestically and internationally. Americans are living longer, are better educated, and have higher incomes than ever before. Since 1960 the number of families living below the poverty line, which itself continues to rise, has been nearly halved to 12.1%. An example of the seemingly never-ending drumbeat of negativism was a recent Washington Post article with the headline, "As Income Gap Widens, Uncertainty Spreads" which bemoaned the shrinking of the American "middle class." If, however, you read through to the end of the article and studied the charts you would see that the number of households earning the median income or less in 1967 was 75.1%, but by 2003 the percentage earning the median income or less had declined to 55.9%. So, contrary to the tone of the article, the middle class is shrinking because more households are now earning above the median. While we read the banner headlines about record levels of consumer debt, we missed the "in depth" coverage about the record level of American net worth which supports that debt. Even the Wall Street Journal buried the article that reported that from mid-2003 to mid-2004 the number of millionaires rose by one third to 8.2 million households.

And it’s not just in the United States that things continue to improve. Danish Professor Bjorn Lomborg planned to write a "Club of Rome" type book to detail the upcoming problems Homosapiens will face. But, jumpin’ jiminy, when he finished his research he found that things were getting better worldwide, with life expectancy increasing, educational opportunities expanding, and economies growing. Old Bjorn runs the risk of being drummed out of the "doom and gloom" brotherhood. The IMF predicts in its most recent World Economic Outlook that aggregate real GDP for the 175 countries covered will grow by 5% in 2004, which would be the fastest growth in almost thirty years. So much for the end of the world as we know it!

Politicians will take credit for all this "success," but it’s really an increasing global commitment to free trade, open markets, and limited government that works. Politicians are always ready to try to meet the insatiable demands of the people for a free lunch, but deregulated, free markets have a nasty tendency of pointing out that there are costs to free lunches. Often free markets help in correcting mistakes that politicians are unable and unwilling to face up to.

George Bush and the Republican Party currently control the political playing field, but the American people are a pragmatic lot, and if the Republicans continue to merely cut taxes while increasing spending and government intervention into the economy they will be toast. In spite of being based in Washington, Montgomery Brothers feels that politicians’ impact on the long-term health of the economy is far less than the American people’s continued commitment to hard work, free markets, property rights, education, and innovation. People grow economies; governments create entitlement programs. Keep it up and we too could be like Japan or Western Europe. MBI is optimistic that this won’t happen and will strive, like Monty Python, to "always look on the bright side of life."

And we’re done with being girly men economists, worried about a recession around every quarterly corner. Recessions are becoming less frequent, shorter, and shallower. In spite of all the angst over jobs, the unemployment rate is lower than its average during the expansion of the 1990s—now considered the "good old days." A recent Gallup poll shows that job satisfaction has been increasing steadily since 1989 and that 50% of US workers are completely satisfied with their jobs.

And what of the twin deficits—budget and trade? Both are being widely forecast as the certain cause of our economic ruination as they have been for the past thirty years. In spite of the growing deficits under "W," real per capita GDP is up 5.5%, real disposable income is up by 6.9%, and per capita real consumption is up by 8% since he took office. While not great, it beats the proverbial sharp stick in the eye. Sure it would be nice to balance the budget, but there is no stomach for it with the public, let alone the politicians. But nor has there been in Western Europe and Japan where economic growth is half of what it is in the United States. Nevertheless, we probably should see both deficits start to decline over the next year or two for no other reason than the certainty of their growth is front page news.

The economic bugaboo du jour is the dollar, which has been going down against most currencies—especially the Yen and Euro. MBI does not claim that deficits don’t matter but doubt that they’ll lead to our immediate demise. This $ dilemma is being hung on the aforementioned bad boy deficits. Since 1980 the United States has created 36 million new jobs, our stock market has increased ten-fold, we won the cold war, and the net worth of US households tripled to record levels even while debt has declined as a percent of national assets.

The relative economic strength of the U.S., and the dollar’s role as the major reserve currency contributed greatly to its earlier strength. A better explanation of its recent weakness is that the dollar became overvalued and that the Fed, by golly, just printed too darn many of them. Take a look at the chart below which shows the trade weighted value of the dollar since mid-year 1987.

It looks to us that the dollar is closer to a low than vulnerable to further major declines. MBI warned of possible dollar weakness back in 2000 and 2001 after it had appreciated for many years. You’re always most vulnerable when you’re ahead.

Without trying to be too "rosy scenario" optimistic, we believe that the economy will continue to surprise on the upside. In spite of six consecutive quarters of above average growth, many expect an economic slow-down. MBI believes that growth will continue above its average historic rate and above the average consensus forecast (see Chart 2 below).

Nor are we overly concerned about inflation although we do watch monetary policy with a jaundiced eye and look to gold as an early warning system. As you can see from Chart 3, the dollar price of gold looks, to us, close to a top.

Business should be the catalyst for economic growth next year through a combination of increased capital spending, inventory (re)building, stock buybacks and/or higher dividends, and continued merger and acquisition activity. Forecasts are for more hiring and some pickup in wage increases, both of which should help sustain consumer spending. Fiscal policy should become less expansive (i.e., the budget deficit should decline at least as a percentage of GDP), which would somewhat reduce growth. The trade deficit might stop increasing, which would (statistically) add to growth.

Net, net—another solid year of economic growth with continued low inflation. Not, not—the end of the line.

Bond market investors are by nature a conservative, if not pessimistic, lot. Bonds, with the exception of "junk," usually do better in a weaker economy. We, like virtually (and we mean almost) everyone got bonds wrong in 2004. Short-term interest rates increased, as most forecasted, but longer-term rates were flat to down, while almost everyone forecasted an increase. Shown below is a chart showing the US Treasury yield curve from year end 2003 to year end 2004.

While many forecasted that the yield curve would steepen during 2004, MBI believed that the yield curve would flatten as longer maturity interest rates would rise less than shorter term rates. Hey! We were at least half right!

Many are now saying that the flattening yield curve is a precursor of bad things to come. MBI believes that the yield curve is now much closer to a "normal" slope and feel that this flattening bodes well for the economic and inflation outlook.

MBI is not overly bearish on bonds and is actually becoming cautiously optimistic. Given the decline in bond yields over the last twenty years (see Chart 5 of 10-year US Treasury yields shown below as a proxy), we can’t see rates going a lot lower.

We could see rates settle into a much lower trading range (of, say, 4% to 5 ¼% on the 10-year UST yield). If the Fed continues to raise its short-term interest rate targets, and MBI believes that it will, any near-term increase in long-term rates could prove muted and might lead to a buying opportunity around mid-year. There are lots of caveats involved, but aren’t there always?

The S&P 500 appreciated by 9% for 2004 which is awfully close to its long-term average of 11% and close to the average of final years of the four-year presidential cycle. Most of this return came during the fourth quarter. We won’t bore you (further) with our rationales, but we will say that we expect this jagged pattern will persist. MBI continues to forecast annual returns from stocks will be less than in the past AND that the lion’s share of those returns will come in short periods of time which will be followed by longer periods of boring consolidation.

In spite of relatively high valuation (see Chart 6 below), MBI is positive on the outlook for equities.

There is a strong correlation between low economic volatility and high asset valuation. Price/Earnings multiples and other equity valuation methods should be near record highs when interest rates are near record lows. Additionally, while most worry about the next stock market correction, or worse, we point out that the wolf is seemingly always at the door. Nevertheless, the stock market rises about 70% of all years for which there are records. We are somewhat concerned with the short term, since "investor" sentiment has risen with stock prices, but there’s nothing new with that phenomenon and bullishness would surely decline with any, and every, market correction. The underlying technicals look strong and the fundamentals are better than most perceive.

Our friend and partner Frank Cappiello points to the four M’s (Money, Mood, Momentum, and Mergers & acquisitions) as being the key determinants of stock price movements. All are currently positive. Additionally, MBI predicts that corporate profits will grow around 10% in 2005, slower than in 2003 and 2004 but certainly no disaster. We’ll gladly take a return of 9% again in 2005 which would be greater than what we expect from bonds and certainly better than from cash equivalents.

In 2004 MBI forecasted that large cap, blue chip stocks would outperform their smaller cap, lower quality brethren. It didn’t happen (as you can see from the chart below), but that doesn’t deter us from forecasting that it will happen in 2005.

We like large cap oil stocks even though we believe that oil prices will be far more stable this year than in 2004. If, as we expect, the business sector improves, the industrial sector should be interesting. Also, if consumers become a bit less ebullient, consumer non-durables should do better than consumer cyclicals. As always, each investor’s strategies should center around their objectives and risk tolerance.

I like my new-found optimism and hope to be able to maintain this New Year’s resolution for as long as I kept my last one. I promise not to become a wild-eyed optimist who predicts only blue skies and green lights. However, we would all do well to follow the old adage: "Remember as you go through life, whatever be your goal, keep your eye upon the donut and not upon the hole."

January 1, 2005
John E. Montgomery