Third Quarter, 2006
Investment Outlook Update
August 17, 2006
Dog Days.
Time was that things pretty much ground to a halt in Washington during August. Congress would leave town, the President would go on vacation, and DC would be an increasingly nice place to live. But times change and August is pretty much like any other month now. Sure, Congress still leaves town and the President goes on vacation but the normal hassles of the other 11 months of the year continue unabated. You would think that with Congress on recess, politics might move to the back burner. But it's an election year and we've even had a few primaries to contend with this month. For instance, Ned Lamont (newbie Liberal Democrat) defeated Joe Lieberman (oldie Liberal Democrat) in the Connecticut Democratic primary. This supposedly showed the political punditry that incumbents, in general, and Republican incumbents, in particular, would take a beating in November.
The public seems pretty fed up with the status quo and, in order to show their displeasure at elected officials for not being able to compromise on difficult issues, they will elect even more hard line ideologues to send to Washington. Doubtlessly, this will lead to a more bipartisan climate in D.C. The Republicans must wake up every morning and thank God that the Democrats are their competition. For surely, if they were anything other than Democrats, they would hand the Republicans a bloody beating in November.
Meanwhile, things go from bad to worse in the Middle East, and terrorism has once again raised its ugly head in Great Britain. One would like to think that such things might lead to a rational discussion of how to handle these issues, but not so. Virtually everything is now instantly politicized and passed through the prism of election-year hoopla. It's a good thing that not many people pay attention to this in August and we would certainly be better off if we paid no attention to it at all. But, in the information age, we’re all exposed to everything 24 / 7 and it contributes to the angst and uncertainty that the financial markets hate.
Economic Outlook
As predicted, economic growth slowed during the second quarter but, unfortunately, even more than was generally expected. While most optimistically forecast a “soft landing,” there are increasing concerns that the soft landing might be much harder than initially believed. While 2.5% growth is far from a recession, forecasts of a recession have increased. Montgomery Brothers believes that the probability of a recession is 100% but it will be much later rather than any time soon. The steady drumbeat of a crash in the housing market drowns out almost any other positive news. Even though new job formation has been lower than hoped for or expected, over 100,000 jobs per month have been added to the employment rolls so far this year. More importantly, income is growing and consumers remain fairly upbeat. In spite of soaring energy prices, people go about their business of consuming, going on vacation, and living their lives as close to normally as could be hoped for.
Members of the FOMC meeting keep telling us that as the economy slows, inflationary pressures will diminish. Montgomery Brothers does not believe that growth causes inflation. However, we fear that since the Fed believes this and if inflation continues at its current rate, or accelerates, the Fed will raise rates and ultimately cause a recession.
The federal budget deficit continues to shrink in spite of federal spending above the nominal growth of the economy since, ironically, tax receipts continued to grow at well above the nominal growth of the economy. Why even the trade deficit has shrunk slightly over the past few months in spite of rising oil prices. Industrial production and orders for capital spending related equipment continue quite strong. Foreign economies similarly show above expected growth. But it's hard to find this good news amongst all the bad. Unsurprisingly, the end of the world might have to wait. At least until everyone gets back from vacation!
Interest Rate Outlook
Well, it seems that seventeen straight increases in the federal funds rate might be enough, at least for now, as Ben Bernanke and the Fed decided to take a bye at the last FOMC meeting. Under Alan Greenspan Fed policy seemed to follow an “often wrong but never uncertain” philosophy. Market participants often had a high degree of conviction as to future Fed moves. Unfortunately, under Ben Bernanke, the Fed has adopted an often wrong but always uncertain philosophy. Under a monetary policy that is “data dependent,” market participants seldom know what the Fed might do next. It's one thing to fly by the seat of one's pants, it's another to let everyone know that’s what you’re doing.
The outward signs of inflation reflected in the consumer and producer price indices remain above the Fed’s indicated comfort level. Nevertheless, the Fed keeps telling us that the economy will slow and that, in turn, will lead to lower inflation. There’s an old joke that says that economists use decimal points to show that they have a sense of humor. So we chuckled when we saw that in the future the government will report inflation data to three digits to the right of the decimal point.
At Montgomery Brothers we believe in following market indicators of inflation. With commodity prices, in general, and gold, in particular, continuing to show an upward bias and the dollar continuing to show a downward bias we remain more concerned than many about inflation. Inflation is a monetary phenomenon caused by creating too many dollars hence reducing the dollar’s purchasing power. It is only later that this reduction in purchasing power is reflected in the general price indices. Unfortunately, the Fed’s creation of too many dollars has been going on for quite some time and, therefore, inflation could prove more intractable than is commonly believed. This would further add to the current angst of the financial markets. Next FOMC meeting: September 20th – Stay Tuned!
Stock Market Outlook
There's an old saying on Wall Street that you should “sell in May and go away”. Historically, not much good has happened to stock prices during the second and third quarters of the year. Certainly, if you had sold in early May and went away, you'd be a happy camper this August. While we are catching one of our periodic rallies, and we’re certainly overdue for one, we can't help but think there's more of the recent drip drip drip of this market that we’ll have to put up with.
We have been disappointed with the way the market has reacted to yet another good quarter of corporate earnings. No matter how positive an earnings report might have been, there was usually something in the details to make “investors” sell a stock down. This is not the sign of a healthy market. Additionally, the deterioration in the technicals is disconcerting. Nevertheless, the market averages continue to trade in a narrow band. Fortunately, we do believe that there will be a fourth-quarter rally for the stock market. We base this on good valuations for stocks, on the four-year presidential cycle and on seasonal factors. Montgomery Brothers continues to see good value in large capitalization blue-chip stocks, energy related shares and more defensive issues. Institutional investors have been flocking to more aggressive strategies, especially those of hedge funds. MBI tries to follow a somewhat more contrarian approach to investing. So, playing it safe might prove rewarding for the first time in years.
We hope that all of you are enjoying your summer. Lastly, we can't help but do a little chest thumping since we have produced this brief Investment Outlook update using Dragon NaturallySpeaking 9.0 speech recognition software. Who says you can't teach old dogs new tricks? Woof! Woof!
August 17, 2006