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Mid-Third Quarter, 2005
Investment Outlook Update
November 18, 2005
Full of Sound and Fury, Signifying Nothing
Shakespeare’s
Macbeth
There’s a lot of
noise out there,
people, so be careful. One of the ironies of the information age
is while
there is so much more information, it seems to have less informational
content. It’s more like noise than news.
Take the recent off-year
elections. The Democrats hold the governorships of Virginia and
New Jersey and we are (mis?)informed that there is a political
sea-change occurring. While
few will deny that George Bush is a controversial and, at least
currently,
unpopular President, the death knell for conservatives, in general, and
Republicans, in particular, might be a wee bit premature. There
is no doubt Bush’s
popularity has plummeted. Why, it’s as low as Congress’ and only
slightly
below that of Democrats. The idea that these recent elections
will straight
line to the Democrats retaking the House and Senate in 2006, is beyond
ludicrous. But to read the papers and listen to the evening noise
(err, news),
it’s a “slam dunk.” If anything, this handful of local elections
may presage a
swing by both Republicans and Democrats back toward the
political
middle. While the press and pundits babble on about how the
Republicans have
“lost their discipline” maybe a few of them are finding their way and
possibly
even a little political backbone. Well, you can always hope.
There have been a few
small and tentative steps by a handful of politicians towards fiscal
responsibility, but small and tentative are the operative
phrases. “Spending cuts”
are too often euphemistic for reducing the rate of increases in
spending and
seldom, if ever, real reductions. All too often, even tiny
reductions in the
rate of increase are met with deafening screams from each and every
special
interest and their political patrons. “Tax reform” is similarly
greeted with
howls of pain from every beneficiary of political largess who might see
their
stipend reduced. The lack of spending restraint and the
unlikelihood of (real)
tax reform could negatively impact the 15% capital gains and dividend
tax rate extensions
which may become casualties of this new found fiscal
responsibility. We hope
not.
Virtually every
second-term presidency in the last century has been plagued by
plummeting
popularity and by scandals. In fact, second-term presidencies are
the most convincing
argument to move to a single, six-year presidential term. (But I
digress.)
Political sea-changes are few and far between and the Republicans ARE
in
disarray, at least for now. But the fact that the Democrats have
no plan, few
clues and only a handful of attractive candidates, might be viewed as
negatives. Also, the Democrats have the Republican’s most
valuable player –
Howard Dean! who recently coined the term “Merlot Democrats” to
describe the
party’s core constituency and supporters. Would you want to be
known as a
“Merlot Democrat”? Ahhhhhh!
Economic Outlook
Similarly, we keep
hearing and
reading about the impending collapse of the U.S. economy. After
ten
consecutive quarters of GDP growth above the thirty-year
average, one
would think that maybe you’d hear some positives. You’d be
wrong. The
argument that fifteen quarters of economic growth, a doubling in oil
prices,
thirteen consecutive increases in the Fed funds rate and a couple of
devastating hurricanes might lead to an economic slowdown is pretty
convincing. While few are flat out predicting a recession,
forecasts of
“stagflation” (slow growth, higher inflation) abound. We admit
that we
continue to be impressed by the U.S. economy’s resilience and we’ve
been in the
positive camp. MBI remains in the minority of economic
bulls.
In general, good news
continues to be drowned out by bad noise. The consumer continues
to plow
ahead, refusing to buckle under to the rumors of their demise.
Global
economies continue to expand. (Why even Japanese and European
economic growth
might rocket into low single digits.) Corporations are, by and
large, flush
with cash and a capital spending pick-up seems probable.
Inventories are low
and the trade deficit is likely to improve as oil prices return to
normal.
On the negative side
of the recession argument, the long-forecasted real estate bubble
(we’ve seldom
heard such dogged forecasting persistence) might be starting to
deflate. A
dramatic bursting is unlikely, but the “told-you-so’s” could prove
psychologically negative but definitely will be deafening. And,
our friends at
the Fed are likely to keep raising rates for a bit longer, adding to
the
negative chorus. MBI continues to believe that growth will be
higher and
inflation lower than the consensus is forecasting. That’s been
our story and
we’re sticking with it.
Interest Rate Outlook
“Are you now or have
you ever
been….an inflation dove?” This is the type of tough questioning
that the press
and politicians had for Ben Bernanke who was unanimously approved to
succeed
Alan Greenspan as Chairman of the Federal Reserve. Given 25 years
of hard
fought victories against inflation and a sense of institutional
propriety that
is legend at the Fed, it’s highly unlikely that Bernanke would admit to
being
an inflation dove – even if he was. MBI expects little, or no,
change in Fed
policies for the foreseeable future but that’s easy to forecast when
monetary
policy is flown by the seat of the Fed’s pants. The discipline of
inflation
targeting could be an improvement.
Alan Greenspan is a
legend and is highly revered by most politicians and members of the
press. He
has single-handedly saved the economy and financial markets from ruin
on many
occasions and is largely responsible for most, if not all, of the
successes of
the global economy and financial markets for the past eighteen
years. Or, so
the story goes! The real story is that the Fed has a great deal
of moral
suasion over the economy, has control of the Fed funds rate at its
disposal, and
the ability to buy and sell U.S. Treasuries for its own account.
(This last
item is the true building block of inflation.) But it really is
not the all
encompassing economic power that it’s cracked up to be. It is
much more
interesting to make it seem as if the Fed, in general, and the Fed
Chairman, in
particular, are like the “all and powerful Oz.” The fact is that
the financial
markets are able to, and would, discipline the Fed should it drift very
far
from anti inflation orthodoxy. Once upon a time the Fed actually
carried a
much bigger stick and, while MBI understands the important role it
plays, much
of the Fed’s cachet is a figment of press and politicians’ hype and
imagination.
Meanwhile, short-term
rates continue to rise and the yield curve continues to flatten.
The
flattening yield curve remains Montgomery Brothers’ greatest economic
concern.
In all likelihood, the Fed has two more turns of the monetary screws
under
Greenspan then one or two more under Bernanke, who needs to show his
inflation
fighting “bona fides.” The Fed has a history of overdoing it but
our guess is
that, while Greenspan doesn’t want to be seen as soft on inflation at
the end
of his term, Bernanke certainly doesn’t want to be blamed for a
recession at
the beginning of his. Stay tuned!
Stock Market Outlook
Montgomery Brothers
has long been
impressed by the ability of the press and the pundits to explain
virtually
every wiggle and jiggle of the stock market. We are still,
however, waiting
for a plausible explanation of why the Dow dropped 500 points in a
single day
in October of 1987. Meanwhile, as the major stock averages
continue to trade
in an historically narrow range, each wiggle and jiggle seems to take
on
greater and greater significance. All the while, it’s becoming
harder and
harder to outperform the market averages even as the pressure to do so
builds.
As we drift towards the end of 2005, these short-term performance
pressures
will increase since year-end bonuses for all too many hinge on
it.
The sectors which did
the best (energy and utilities) during the first three quarters, have
done the
worst so far in this quarter while some of the sectors which had
performed
poorly earlier in the year (financials and materials) have been among
the best
sector performers so far during the fourth quarter. Noisy
explanations abound.
Seasonally, November
and December have (historically) been a favorable time to be invested
in the
stock market. The old “Santa Claus Rally,” don’t you know?
But nerves are
frayed as this disappointing and frustrating year limps towards its
end. And, as
it does, the performance pressures build as underperformers strain to
get ahead
and out-performers try to hold their gains. This might explain
why ± 100 point
days on the Dow have been twice as frequent so far this quarter as they
were
earlier in 2005.
MBI remains nervously
and cautiously optimistic on the stock market outlook into year-end
2005 and
early 2006. However, given what we see as full valuations and
deteriorating
technicals, we are more nervous and less optimistic than we were
earlier. We
will listen to all of the noise emanating from Washington and Wall
Street but
try to pay it little heed. It is, after all, more noise than
information and
often signifies nothing or at least not
much.
November 18,
2005
John E.
Montgomery