THE ECONOMY UP…STOCKS DOWN

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
May 11, 2004

IN THIS ISSUE:

1. The Economy Continues To Get Better & Better.

2. Fed Moves Closer To A Rate Hike – But When?

3. Stocks – Another Good Buying Opportunity?

4. Bonds – Look Out Below, Think High Yield.

5. Gold Plunges & The U.S. Dollar Holds Firm.

6. Results From Barron’s Big Money Poll.

7. Conclusions – What To Do Now.

The Economy

The Commerce Department reported on April 29 that Gross Domestic Product rose at an annual rate of 4.2% in the 1Q. That number was less than expectations although still very solid. For the 12 months ended March 31, GDP rose by 4.9% according to the Commerce Department.

The main reason the GDP number was below advance estimates of around 5% was that companies added less to their inventories than projected in the 1Q. This is actually a positive point for growth during the rest of this year. The GDP report also stated that personal consumption spending rose by 3.8% in the 1Q. That, along with the latest strong economic reports, especially durable goods orders and retail sales, suggests that manufacturers will have to scramble to rebuild inventories now and in the months ahead. This means more jobs as I will discuss below.

I continue to expect this economy to surprise on the upside for the balance of this year, especially in light of the latest low inventory numbers. In a nutshell, we have productivity at a 50-year high and interest rates that are still at 45-year lows. GDP could easily rise by over 5% during the next 2-3 quarters or longer.

The price index for gross domestic purchases, which measures prices paid by consumers, increased 3.2% in the 1Q, compared with an increase of 1.3% in the 4Q. Excluding food and energy prices, the price index for gross domestic purchases increased 2.3% percent in the 1Q, compared with an increase of 1.5% in the 4Q.

Fed Clears Way For Rate Hike

The Fed Open Market Committee left short-term interest rates unchanged at its May 4 policy meeting. In its post-meeting statement, the Fed dropped the prior language which said the Fed “can be patient” about raising rates. Instead, they added new language saying that Fed policy can be tightened but “at a pace that is likely to be measured.”

The FOMC statement also contained language that indicated a rebounding economy, with solid growth and better hiring. Curiously, though, the statement also said the Fed’s latest assessment is that the possibility of an economic slowdown versus an acceleration are roughly equal. This means two things. First, it means the Fed remains at least somewhat concerned that deflation could still develop. Second, it leaves all their options open, which in this case means they could still elect not to raise rates until after the election.

Alan Greenspan testified before Congress on April 21 when he said, “Recent data suggest the worrisome trend of disinflation presumably has come to an end.” Many market analysts took this comment as an acknowledgement from Greenspan that the risk of deflation and disinflation had passed. This was seen as the sure signal that rates would begin to move higher, perhaps even at the May 4 FOMC meeting.

Yet the language in the May 4 statement, suggesting that the risk of an economic slowdown versus a further acceleration are roughly equal, now has some analysts wondering if the Fed will raise rates or not.

As I have suggested in recent E-Letters, the Fed’s decision will very likely depend on upcoming economic reports. The latest GDP report showing growth of 4.2% in the 1Q is not, in my opinion, particularly troubling to the Fed. Had it been in the 5%-6% range as some analysts had expected, then the Fed might well have raised rates a quarter-point, or even a half-point, at the May 4 meeting. However, given that the GDP price indicator rose 3.2% in the 1Q, this raises the odds of a rate hike before the election.

My guess remains that the Fed will watch the economic reports very closely between now and the June 29/30 FOMC meeting, and either raise rates at that time or not raise them until after the election. I don’t believe Greenspan wants to raise rates in August or September, so that increases the odds of a rate hike on June 30 in my opinion.

Job Growth Continues To Improve

The Labor Department reported on Friday that the unemployment rate fell to 5.6%, and the economy added 288,000 new jobs in April. Advance estimates for April jobs were only around 170,000. The government also revised the March number upward from 308,000 to 337,000 new jobs. For the four months ended April, the economy has added 867,000 new jobs, a sharp turnaround from the year-earlier period when the economy was actually losing jobs.

The best news in Friday’s employment report was the fact that higher paying jobs are finally making a comeback. Prior to April, most of the newly created jobs were in low-paying sectors. In April, however, the largest increases in jobs came in professional and business services, which are among the higher paying sectors. April saw strong job growth in management consultants, oil and gas, architects and engineers. The strongest job sector was in Internet publishing.

Durable goods manufacturers also added jobs in April according to the latest report. That was a welcome sign after 42 consecutive months of job losses in the factory sector. This should only improve in the months ahead as manufacturers add labor to rebuild inventories as discussed above.

The strong job growth report on Friday, while welcomed, also caused analysts to conclude that the odds of a Fed interest rate hike at the June 29/30 FOMC meeting have increased. That is consistent with my conclusions just above.

Good News Or Bad News – The Markets Swoon

Both stocks and bonds declined in April, and the latest strong jobs report didn’t make things any better. It is not uncommon in the investment markets for good economic news to be viewed as bad. A stronger than expected jobs report should be good news, right? Yet the latest strong economic news has investors worried that interest rates will rise soon.

In addition to the strong economic news prompting fears of higher interest rates, the equity markets are also troubled by new highs in oil and gasoline prices and worsening conditions in the war in Iraq. As a result, many investors elected to throw in the towel in April and so far this month.

Stocks once again declined to below 10,000 in the Dow and below 1,100 in the S&P 500 on Monday. That selloff put us back to the key support levels where the equity markets bottomed in March. If they manage to hold in this area again, it will be a strong technical indicator which could usher in a new uptrend that could carry through the election or longer.

The professional equity Advisors we recommend are currently partially in cash and partially “hedged” (using specialized mutual funds that go up when the market moves down). Thus, they have side-stepped most of the latest decline in stocks. Even though I expect stocks to trend higher later this year, market conditions remain very volatile, and there will be periodic downturns such as we are seeing now. This is why it is so important to have active managers that can hedge or go to cash if market conditions warrant.

CLICK HERE for more information on the equity Advisors we recommend including their past performance records, net of all fees and expenses. (Past results are not necessarily indicative of future results.)

A further decline in equities is not the most likely scenario as I see it. I view the current selloff in the stock markets as a buying opportunity. Current fears about an interest rate hike have been overblown in the markets in my opinion. Good economic news is eventually good for the equity markets.

Bonds Continue To Get Hammered

Fears of higher interest rates and inflation continue to weigh on the bond market. Treasuries and high-grade corporate bonds have been the hardest hit. Yet the decline in bonds comes as no surprise to readers of this E-Letter. For a year now, I have been advising readers to reduce exposure to these bonds. I hope you took that advice.

The May 6, 2003 issue of this E-Letter focused on high yield bonds, also known as junk bonds. In that E-Letter, I explained how high yield bonds can actually benefit from a recovering economy, and how high yield bonds can go up even when traditional bonds like Treasuries are going down in value.

I also explained how investors can reduce the risks of owning high yield bonds by investing in large, well-known mutual funds. These large funds typically own hundreds of different issues of high yield bonds, thereby reducing the default risk considerably.

In that May 6 issue last year, I also introduced you to the best high yield bond manager I have ever recommended. CLICK HERE for more information on this Advisor, including their outstanding performance record, net of all fees and expenses. (Past results are not necessarily indicative of future results. High yield bonds are not suitable for all investors.)

Since May of last year, high yield bonds have been the big winner. The Credit Suisse/First Boston High Yield Bond Index has risen 17%. As of today, 30-year Treasury bonds are down over 10% from the peak last June. Unfortunately, T-bonds and related bond funds were the “darlings” in the investment world about this time last year, and many investors are now sitting on large losses. Again, I hope you are not one of them.

Even though high yield bonds have had a nice run, I do not believe it is too late to get onboard, especially if you use an active professional manager who can hedge or move to cash if market conditions warrant. If you have not looked at our recommended high yield bond manager, maybe it’s time you did. Click on the link above.

The U.S. Dollar & Gold

Gold prices have plunged from the high near $430 in late March to $375 per ounce. This sharp decline occurred despite the boom in the economy and the rise in inflation. Many investors bought gold and/or mining shares when gold broke out above $400, and now they are sitting on losses. The decline in gold and other metals is attributed largely to the rise in the US dollar and worries that China’s economy is slowing down. The Chinese government ordered banks to reduce lending at the end of March, and analysts fear that will mean a significant drop in demand for metals.

I don’t make predictions or recommendations on gold in this E-Letter. Gold, like many other commodities, is just too volatile to forecast in a weekly format such as this. And as I have written in the past, when gold falls, it almost always drops like a rock. In fact, I don’t even try to predict gold prices. I leave that to the professional Advisors who manage money in some of the specialized funds we offer.

The US dollar declined more than 25% from the peak in early 2002. Since the low in February, the dollar has risen about 7%. The dollar is benefiting from the stronger US economy and higher interest rates. The Bank Credit Analyst believes that the long-term trend in the US dollar remains down. However, they also believe that the dollar will remain relatively firm for the rest of this year, again benefiting from the expected rise in US interest rates.

Like gold, I don’t make currency recommendations in this E-Letter. I leave that to the professional currency Advisors who manage money in some of the specialized funds we offer.

Barron’s Big Money Poll

Twice a year, Barron’s surveys over a hundred professional money managers around the country to get their outlook on the markets, interest rates, the economy, etc. Here are the latest results from their spring survey.

As for the stock markets, 61.3% of respondents were bullish, while 26.7% were neutral, and only 12% were bearish. Among those bullish, the average estimates for where the markets would be at the end of this year were: Dow Jones up to 11,042, S&P 500 up to 1212, and the Nasdaq up to 2146.

Their favorite stocks: GE, Pfizer, Microsoft, Apple, Baxter International, Berkshire Hathaway, Flextronics, Intel, Nokia, Sirus Satellite Radio, Time Warner and UTStarcom.

Most overvalued stocks: Taser, Amazon.com, Yahoo, Research In Motion, Cisco, Applied Materials, Genentech, Krispy Kreme, Starbucks, Verizon and XM Satellite Radio.

On the economy, the average estimate of GDP growth for 2004 was 4.17%, and the average forecast for 2005 was 3.22%. On inflation, the average estimate of CPI for 2004 was 2.25% and 2.72% for 2005. 90% of the money managers polled expected interest rates to rise over the next year.

Conclusions – What To Do Now

As I have predicted for over a year, the US economy continues to surprise on the upside. The latest unemployment report confirms that the last piece of the economic puzzle is falling into place. The recovery is on very solid footing and GDP could grow at a 5% or better rate in the second half of the year, barring any major surprises.

The Fed is going to raise interest rates – it’s just a matter of when. Odds have increased for a quarter or half-point increase at the June FOMC meeting, but I continue to believe that will only happen if upcoming economic reports are quite strong.

Stocks have over-reacted to interest rate fears, in my opinion, and we are probably witnessing another good buying opportunity. The next few days should tell the story. In any event, the equity markets will remain quite volatile, and I continue to recommend active professional money managers who can hedge their positions or even go to cash if market conditions warrant.

More trouble probably lies ahead for the bond markets. There are those who argue that Treasuries and other high quality bonds may have over-reacted on the downside recently to interest rate fears, and they may be correct in the short-term. However, long-term rates are likely headed even higher over the next 6-12 months. High yield bonds, on the other hand, may continue to do well along with the economy. Here, too, I recommend active professional management.

If you aren’t sure how to invest in this volatile environment, I invite you to call us at 800-348-3601. I have Certified Financial Planners and investment professionals on my staff who will be happy to visit with you, and there is never any pressure to invest. Or visit our website at www.profutures.com.

Very best regards,

Gary D. Halbert

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