MONTGOMERY BROTHERS

In one of the most hyped and anticipated economic “happenings” of 2005, the Chinese recently revalued their currency. While the financial markets reacted with a resounding yawn, most regarded the move as “a good first step.” Remembering that everyone who has ever walked the plank started with a good first step, we are reminded of the old joke of the guy who jumps off the top of the Empire State building and is heard to say as he passes the fiftieth floor “so far, so good!”

The highly anticipated, widely forecasted and politically demanded yuan revaluation also reminds us of two ironclad rules of economics and investing – don’t wish too hard, you may get what you want and never underestimate the law of unintended consequences. For some classical economic reason which has consistently failed in the real world, many believe that an appreciation of the Chinese (or any other foreign) currency will benefit American exporters whose products could become more attractive to the Chinese without hurting American consumers who benefit from the lower prices the Chinese currency peg helped to provide. Decades ago the U.S. browbeat the Japanese into revaluing their currency. Since then, the yen has quadrupled in value against the dollar while the U.S. has continued to run a trade deficit with Japan. Besides, if trade deficits are so wonderful why are the German and Japanese economies, which consistently run trade surpluses, both in the tank? As for the unintended consequences? They’re unintended, so who knows?

Politicians labor under the misconception that, somehow, trashing one’s currency leads to economic success. Such policies might make political sense, but economic sense? Unlikely. The Chinese have only let their currency appreciate by 2.1% versus the dollar but “so far, so good!”

Economic Outlook

In spite of years of above average economic growth and below average inflation, the U.S. economy is largely viewed as off-track and in trouble. The consumer is always just about to pack it in and quit spending, foreigners are certainly going to stop funding the U.S. trade and budget deficits, the value of the dollar will collapse, oil prices are going to kill the recovery and ruin corporate profits, the economic benefits of the expansion aren’t being evenly distributed, the housing bubble is about to burst. It’s always something, and yet, “so far, so good!”

Montgomery Brothers has been and continues to be positive on the economic outlook. Sure, we’d like to see consumers save more money but believe the currently stated 0% savings rate is highly misleading and that consumers, rather than strapped, are in pretty decent shape. Corporations remain flush with cash and are generating record corporate profits which are being paid out in dividends and in share buybacks even while capital spending has been rising. Inventories have been worked down, even during the “slower” second quarter GDP which showed only 3.4% growth. The budget deficit is shrinking due to the high growth in tax revenues (yet another sign of a strong economy) while the trade deficit seems to be stabilizing.

The Fed is raising interest rates because, for some illogical economic rationale, it believes that economic growth causes inflation. The Fed is forecasting 3.5% growth with core inflation of 1.75% to 2.0% for 2005 with only slightly slower growth but no faster inflation in 2006. This hardly seems to us to be some sort of foreboding economic disaster looming directly ahead.

MBI is not immune to worries. The price of oil is likely to have at least some negative impact on the economy, in general, and on consumer spending, in particular. (It certainly is negatively affecting the trade deficit by ballooning imports.) Higher oil prices along with higher short term interest rates and higher unit labor costs ought to slow corporate profit growth. Oil prices are already causing higher nominal inflation rates. The “oil-isn’t-as-big-a-deal-to-the-U.S.-economy-as-it-used-to-be” crowd might have it right, but oil prices have more than doubled over the past two years. Their arguments are every bit as convincing as the bond bulls’ case for why interest rates could stay low for the foreseeable future (which were being made at mid-year). But, wait! Interest rates have been going up since mid-year. The “experts” seem every bit as confused as everyone else.

Interest Rate Outlook

The Fed made it 10 for 10 recently when it raised the Fed funds rate by 25 basis points at the tenth consecutive FOMC meeting since June of 2004. So far, the increase of 250 basis points for short term rates has not slowed economic growth, and inflation remains contained. Expectations for future inflation by both the economists and by real people remain subdued. “So far, so good!”

The Fed continues to be puzzled by the refusal of longer term interest rates to dance to its fiddle. The yield curve has flattened dramatically and is now below its “normal,” or average, slope. Let’s hope the Fed isn’t overcome by macho and doesn’t invert the yield curve just to show the bond market who’s boss! The Fed has a history of overdoing it both when loosening and when tightening.

Meanwhile, as alluded to above, there is a growing chorus of interest-rates-will-stay-low forecasts in spite of a still overwhelming bearish majority. It helps that the bond market bulls have been right, or at least they were until quite recently. Most individual investors are underweighted in bonds since, everyone knows, real men don’t invest in bonds. Well, maybe, munies or a little junk, but real “taxable” bonds? NEVER!

But boy! do them foreigners ever like bonds, and a good thing, too! The latest (June) data shows foreigners buying $71.2B of U.S. Securities, even more than the $58.8 billion June trade deficit. Do they know something we and the Fed don’t? When it comes to funding our twin deficits, so far, so good!

Stock Market Outlook

From the lows in mid-April to the widely reported “four year” highs in early August, the major stock market averages showed returns of 6% (Dow Industrials) to 15% (for the Russell 2000) yet remain little changed for the year, as a whole. While we’d like to say “so far, so good!” on this one, too, we’ll go with “it’s a good first step.” While it is statistically possible to prove almost anything, the stock market almost always has a “summer” rally. But now we’re rapidly approaching the statistically weak September/October period. Thankfully, the markets have subsequently rallied into year’s end. All of this of course is “on average” mostly claptrap and nonsense.

Montgomery Brothers continues to see the stock market as fairly valued with little downside risk or upside potential. We continue to believe it’s a stock picker’s market but also feel that sector and industry selection are equally, if not more, important. If you can get the stocks within the sector or industry right, too, you’ll magnify your returns. But sometimes, it’s hard to find attractive stocks and that’s when using ETFs (Exchange Traded Funds) make sense. So far this year, the energy and utility sectors have been the star performers. Energy and Utility stocks don’t usually move in tandem and both seem extended and in need of rest. (Montgomery Brothers continues to like the energy sector for the longer term.) The Industrial and Materials sectors look vulnerable, which is unsurprising this far into an economic expansion. Consumer Staples, Telecommunications and Financial stocks look a little suspect to us, but the Healthcare and Technology sectors look to be improving. Only the Consumer Discretionary sector looks consistently strong.

Second quarter earnings surprised on the upside, again. We would think that since this quarter was the thirteenth consecutive quarter of double-digit operating earnings growth investors would stop being surprised! A recent Wall Street Journal article stated that investors are waiting for stock prices to catch up with earnings but stock prices precede (not follow) and predict (rather than reflect) earnings.

While the market has shown a spirited rally and pundits and investors have become more positive or (at least) more complacent on the outlook, MBI has become a bit more cautious. Since we continue to think that stocks, on average, will give us a 6% to 8% total return for 2005 and since year-to-date the S&P 500 has only given us 3%, we say “so far, so good.”

August 15, 2005
John E. Montgomery