I recently traveled from Washington, DC (Disneyland on the Potomac) to Orlando, FL (home of Disney World) to give a speech to the American Automotive Leasing Association. I enjoyed addressing the group and was even paid. (AALA be praised!) I used my new-found optimism as the theme of the speech. While not too many were buying all my happy talk, I was surprised by how many said they were glad to hear anyone say anything positive about the current economic and investment outlooks.

What is surprising about all of the current negativism is that it comes in the face of so much good news. During the two weeks prior to the speech, the Center for Disease Control announced that life expectancy in the United States had increased to a new record; the Federal Reserve reported that the net worth of the United States had increased to an all-time record high; and the Commerce Department revised GDP for the fourth quarter of 2004 and full-year upwards, showing the fastest rate of economic growth in five years. Americans are by nature an optimistic lot, but you’d never know it from the press or politicians. Dread, disaster, and doom are always directly ahead or, at best, right around the corner.

We won’t bother commenting on the media, but let’s touch on the politicians. MBI is somewhat surprised that during this period of heightened regulatory scrutiny of business people, our elected officials continue in their ways. Take the Social Security debate. Ignoring that Social Security is the largest Ponzi scheme of all time, the effort at addressing this issue in a bipartisan manner almost immediately devolved into yet another political brawl. The president and his minions are pushing private accounts (which even they admit will exacerbate the situation over the near term and provide little real reform over the longer term). The Democrats largely deny there is a problem, let alone a crisis, in the first place. Anyone who has even briefly examined Social Security’s situation knows that some combination of higher FICA taxes, reduced benefits, and older retirement age is necessary. Additionally, there’s lots of lead time to implement any changes with minimal detrimental impact over the near term. Instead of debating issues and seeking compromise, our politicians engage in activities and rhetoric that would quickly land business people in regulatory hell, if not jail. We’ll be surprised if anything positive emerges from this debate.

One of the obvious (at least obvious to us) casualties of the current political situation is the lack of any resolve in limiting government. Runaway budget deficits and rapidly increasing regulatory burdens are happening while Republicans control the executive and legislative branches. The political process works at glacial speeds but currently this glacier is drifting toward Europe. Fortunately, the US economy does have the uncanny knack of continuing to expand, in spite of the politicians.

Don’t economists ever get tired of being wrong? They are almost always surprised, but especially by good news. The recent upward revisions to US GDP and the announcement that corporate profits expanded to record levels—at the fastest pace in years—should have been received by huzzahs and high fives. Instead, warnings of potentially higher inflation and forecasts of diminishing growth expectations were the fare of the day. To economists, every silver lining has a cloud. A lot of clouds. And they’re all dark, very dark.

Without a doubt the current dread du jour is the trade deficit. Instead of viewing the United States as the global economic engine that it is, and the US financial markets as a highly attractive place for foreigners to invest, which they are, the trade deficit can (supposedly) only lead to our demise as a nation. Such warnings have persisted for years. MBI has great confidence that, if left to its own devices, free economies and free markets will resolve issues such as the trade deficit. What worries us more than the trade deficit is what the politicians might do to try to help the situation. We’d be very surprised if their "help" actually helped.

MBI, like most forecasters, expect that economic growth will slow, inflation and interest rates will increase, and corporate profit growth will weaken. We wouldn’t be surprised, however, if economic growth stayed more robust, inflation and interest rates remained low, and corporate profits continue to rise by more than most expect.

A recent National Association of Business Economists poll asked its members to indicate their greatest economic concern. Of the 172 polled, 27% said the budget deficit, 24% indicated terrorism, and near last at 6% was inflation. Until we read that, we hadn’t been that worried about inflation, but with only 6% of economists worried we are now concerned.

MBI believes that inflation is a monetary phenomenon caused by the Federal Reserve being too expansionary with its monetary policy. Shown below is a chart showing the Fed funds rate since 2000.

Monetary policy has been expansionary and in our opinion, has yet to get to "neutral," let alone become tight. As we’ve indicated before, we believe that gold and the dollar give early warnings about inflation and, as you can see from the charts below, the price of gold turned up and the value of the dollar turned down some time ago.

So, we are not surprised that concerns over inflation are now growing.

What we are surprised about is what until recently was the relative lack of concern. Usually, you don’t have to hit the bond market between the eyes with a huge board to get its attention. All it took this time was Alan Greenspan to warn of rising interest rates for a year, to raise the Fed funds rate at six meetings in a row, to testify in front of Congress that interest rates currently posed a "conundrum," and to have the Fed state for the first time in four years that inflation is a concern. In addition, no less of a luminary than Paul Volcher, not one given to intemperate statements, raised inflationary storm warnings during a recent speech at Stanford.

Shown below is the yield curve for 3/31/05 and for a year ago.

Most argue that longer-term rates should be higher, and we find it hard to argue with that. But look back at those charts on gold and the dollar shown above. It looks to us that gold might be topping and/or the dollar bottoming. Far too early to tell for sure, but certainly worth watching. MBI continues to be stand-offish on investing in longer maturity bonds, but if the bond market panics, a buying opportunity may present itself.

Well! That was a disappointing quarter. Especially, since it came hard on the heels of last year’s terrific fourth quarter. Looking at the trends of the past two years seems to confirm a point MBI has been making: that the stock market will be frustrating but with a slightly upward bias. Shown below is the S&P 500’s price movement over the past two years, and we’ve drawn in some trend lines to make our point.

Quick up-moves followed by periods of downward biased consolidation = frustration even if, longer term, it’s moving up.

MBI believes that the stock market is getting increasingly efficient—at least over the intermediate to longer term. Program trading (largely arbitraging the cash and futures markets) now represents more than 50% of NY Stock Exchange weekly volume, and hedge funds are increasing their presence also. Investors, in general, are better informed and more sophisticated than ever. Additionally, the market averages are fully valued. And why not? The economy is expanding at 3.5%–4.0% annually, interest rates are historically low, and S&P 500 profits were up more than 20% over the past year. Corporate balance sheets have improved, and net margins and returns on equity are on average at or near all time highs.

Additionally, corporations are awash in cash but are more likely to increase dividends, buy back shares, and make acquisitions than to use their cash hordes for capital spending. (Even though that’s happening too!) All could help stock prices. Additionally there’s a new and we believe positive factor for the stock market. Private equity funds have amassed huge amounts of leveragable, investable cash. These funds’ acquisition targets will get larger since they have so much money to deploy. The regulatory burden currently falling on public companies makes "going private" an attractive option for corporate managements. Witness the purchase of Sungard Data (SDS – $34.50), which is being taken over by a group of private equity investors for $10.3 B. Expect more and maybe even larger "deals."

Given the fact that the stock market goes up about 70% of the time, MBI is always surprised that investors are constantly looking over their shoulders for the next bear market. Then when it goes up, it’s like Gomer Pyle used to say, "Surprise! Surprise!"

April 1, 2005
John E. Montgomery