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August 2004 Issue
In this issue, I bring you the latest thinking from the editors at The
Bank Credit Analyst. As always, I consider BCA to be one of the
most accurate forecasters of major economic trends, equity market trends and
interest rate trends. In short, BCA predicts that the economy will continue
to grow at a healthy rate of 3-4% over the next year, barring any major
negative surprise such as another major terror attack on our soil.
The economy did slow somewhat in the 2Q. The Commerce Department released
its first estimate of 2Q economic growth at 3%, which was below
expectations. The Index of Leading Economic Indicators and the ISM
manufacturing index both fell slightly in June (latest data available), but
both readings are still above where they were at the beginning of this
year. Also, the Consumer Confidence Index rose again in July to the highest
level in two years. BCA believes that the latest slowdown does not mean a
new recession, and the economy will continue to grow.
As this is written, the stock markets have fallen to new lows for the year.
Does this mean a new bearish trend has developed, or are we still in a broad
trading range? BCA still believes that stocks have upside potential between
now and the end of the year. However, due to recent market action, the BCA
editors lowered their recommendation on stocks from “above-average”
to “average.” They also recommend traditional market
timing strategies and sector rotation for this type of market (see pages
2-3).
As investors struggle in this choppy equity market, many are reaching for
riskier strategies in the hopes of increasing returns. Investment promoters
know this, and there is a ton of bad advice out there. This month, we look
at some of the bad advice and why you need financial planning.
The editors at BCA continue to believe that Treasury bonds and other
high-quality long-term bonds are overvalued, and they maintain their
recommendation of “below-average” positions in these
instruments.
Finally, we take a look at the impact record high oil prices are having on
the economy and consumers. BCA has some interesting analysis on this and a
forecast for lower oil prices (see pages 7-8).
BCA’s Latest Forecasts
In this issue, I bring you the latest forecasts from our old friends at
The Bank Credit Analyst. I have not written about BCA’s latest thinking
in a while because their forecasts and their recommendations haven’t changed
in a while, until their current August issue. As always, I consider BCA to
be one of the most accurate forecasters of major economic trends, equity
market trends and interest rate trends. I have been a continuous subscriber
to BCA since 1977. Their research is quite expensive but well worth it.
Since the beginning of this year, BCA has maintained the following forecasts:
1. The economy would continue to rebound, perhaps surprising on the
upside.
2. Inflation would turn higher, but not by enough to be overly concerned.
3. The Fed would nudge short-term rates up in the second half of the
year.
4. Equity prices would trend modestly higher, especially in the second
half - maintain above-average positions in stocks.
5. Treasury and other long-term bonds are overpriced and are not advised
- maintain below-average positions in long-term bonds.
With the exception of equity prices not rising to this point, Martin Barnes
and his fellow editors at BCA got it pretty much right as usual. So what do
they think now?
First of all, the BCA editors believe the economy will continue to grow by
3-4% for the next year, absent a major negative surprise such as another
serious terrorist attack on our soil.
They believe that inflation, as measured by the CPI, will settle in the 2-3%
range. They also believe the Fed will continue to nudge short-term rates
up, such that the Fed funds rate is 4% or higher by the end of next year
(2005).
BCA Downgrades Equities
BCA’s advice on the investment markets is either “above-average,”
“average” or“below-average”
holdings. After having recommended above-average holdings of
equities over the last year, the BCA editors downgraded their recommendation
to average holdings in their latest August issue. They say:
“The stock market was due for a period of consolidation after rising
45% [S&P 500] between March 2003 and February 2004, almost without a break.
However, what should have been a ‘pause that refreshes’ is turning into a
larger affair. There is still a chance that prices will resume their upward
advance in the second half of the year given still decent earnings growth
and low interest rates... The conditions for a major decline in stocks do
not exist.
…However, there needs to be a catalyst to trigger renewed investor
confidence [in the market]. Investors are weighed down by a long list of
concerns including oil, geopolitics, rising interest rates, the
sustainability of the economic expansion and the outlook for earnings.”
As noted just above, the editors at BCA still believe the stock market may
have some meaningful upside potential, but they also recognize that the
markets could continue in a broad trading range. In fact, their latest most
likely scenario would have equity prices rising only about 5% over the next
year. If true, that will be a major disappointment to millions of investors.
The BCA editors also expect the equity markets to continue to be quite
volatile. They once again advise investors to consider traditional market
timing strategies and sector rotation. They say:
“In a low return world, market timing will become more important and
this means paying more attention to short-run cycles… There will be lots of
mini-cycles for nimble investors to play… Market timing and sector selection
will become much more important in terms of boosting returns to more
acceptable levels.”
Right Up Our Alley
Most of the professional equity managers we recommend utilize strategies
that emphasize sector selection. Their time-tested systems attempt to
identify those sectors that have the potential to outperform the market
averages. Few investors have the ability to do this successfully on their
own, as I discussed last week.
Most of the professional equity managers we recommend also have the ability
to move partially or fully out of the market from time to time as conditions
warrant. Increasingly, these managers are using so-called “short funds” to
hedge their long positions when it looks like the markets are moving into
another downward move in their trading range. Here, too, very few investors
know how to successfully short the market during downturns.
If BCA is correct that the most likely scenario is for the equity markets to
move in broad trading ranges, with a modestly higher bias, then you may want
to consider active professional management for at least a part of your
portfolio – even if you have never done so before. I suggest you take a
look at the successful active managers I recommend.
I recommend Niemann Capital Management and Potomac Fund Management
for equities and Capital Management Group for high yield bonds. You
can see their actual performance records by going to our website at
www.profutures.com or you can call us toll free at 800-348-3601
and we will send you complete information.
The Financial Press Does Investors No Favors, Especially In This Kind
Of Market
What has the financial press learned by going through the most recent market
cycle? Nothing. The press has already forgotten the greed of
1998 to 1999, the fear of 2000 to 2002 and their poor financial advice to
individual investors in both time frames. Their mantra is still that
individual investors can beat the markets on their own, rather than
achieving a real rate of return consistently over time. They advise moving
from one hot investment to the next without looking back. Or from one
investment strategy to the next, regardless of whether or not most investors
can really implement those strategies on their own.
And investors are hungry for ideas that sound good. The three-year bear
market that ended in 2003 dealt serious losses to most investors. Based on
mutual fund money flows, many investors bailed out of the market either
partially or completely in late 2002 very near the bottom.
We also know from those same money flow numbers that most of the investors
who bailed out near the bottom did not get back in to catch the huge
recovery of apprx. 45% in the S&P500 Index from March 2003 to March 2004.
So they are very frustrated at this point, and this includes millions of
Baby Boomers who don’t have that many more years to build their portfolios
for retirement. They are anxious to find something that works.
The Trading Range Market
Right now, the dilemma for investors is what to do in this sideways market
we appear to be stuck in. The sideways market is causing a lot of
second-guessing on the part of the financial press and confusion on the part
of investors who listen to them.
While the equity markets are under renewed pressure as this is written, the
markets are pretty much where they started the year. It appears we may be
at the bottom of a trading range with the S&P 500 at around 1060. The high
side of the trading range appears to be around the 1160 mark. Therefore,
the S&P 500 is down about 9% off its high for this year. Again, considering
that the S&P 500 was up about 45% from its March 2003 low to its March 2004
high point, being down less than 10% from the peak doesn’t seem too bad to
me.
Of course, most investors don’t look at it that way. They are very
frustrated and eager to hear about any strategy that can work in a trading
range market. And the financial press has all kinds of ideas, regardless
of whether most investors can use them successfully or not. Here are some
examples.
Sector Rotation
In a July 16 “Managing Your Money” column in USA Today,
an article dealt with how to play a sideways market. One piece of advice
was to target winning sectors. Great advice! All you have to do is
just pick the winning sectors, ride them up until they are at a peak, and
then sell them before they fall. The problem is identifying these sectors
before they get hot and in time to make a profit.
There are some professional portfolio managers who track the market
day-by-day and use the “sector rotation” strategy successfully. Some of the
professional Advisors we recommend use this strategy, but it is difficult
even for them. However, we’ve seen a lot of professional managers who were
not successful (at least by our definition) in using sector rotation
strategies, especially during the bear market.
If professionals struggle with identifying winning sectors, how many
individuals looking at the market in their spare time can lock on to the
sectors that are performing well in time to pick up significant gains? Who
is going to blow the whistle and tell them when to get out so they don’t
ride those winning sectors down? When was the last time someone in the
financial press told you when it was time to sell something?
Usually the press has moved onto the next hot investment for today and fail
to follow up on the advice they gave yesterday. After all, they are in the
business of selling the latest news. Yesterday’s hot investment or
strategy is now old news.
Traditional Market Timing
After decades of claiming that traditional market timing could not be done
successfully, more and more pundits in the financial press are now
recommending that individual investors try it in this sideways market. As
you well know, I believe market timing can be done successfully, but is best
left to professionals. But just as with sector rotation, we’ve found many
more professional managers who don’t do well with market timing than those
who have been very successful. Very few can do it consistently over time,
even with all the quantitative tools and research at their disposal.
Timing isn’t something for most individual investors to attempt on their
own. They don’t have all the quantitative tools and research. Even worse,
most investors tend to be too emotional and can end up buying high and
selling low. This can be a disaster. Yet the financial press makes it
sound easy.
Buying Only The Best Stocks
Another piece of advice I read recently was to concentrate your portfolio by
buying only the 10 stocks with the greatest potential for appreciation.
Can anyone reading this tell me which are the 10 best stocks to buy? If you
can, we need to talk!
This article assumed, apparently, that most investors know how to pick the
10 best stocks. Just identify the winners and invest only in them, it
said, as if anyone can do it.
If it were that easy, professional managers would never have any losers in
their portfolios. Do you really think a professional manager goes out
purposely to buy stocks they expect to underperform? If managers could
identify those losers in advance with any certainty, they wouldn't buy them
in the first place. How much more difficult is it for amateurs to avoid
losers while selecting the 10 best stocks?
Finally, if the people who write these articles could actually do what
they suggest, do you think they would be working for columnist pay?
No!
Portfolio Rebalancing Not The Silver Bullet
In a July 28 column in the Wall Street Journal, an article dealt with how to
make money whether the market goes up or down. The article says that in
reality you don’t need to guess the market’s direction in order to profit
from shifting valuations. All it takes, the writer says, is a little
self-discipline. Considering that it is very difficult to forecast the
market’s short-term direction, all you have to do is annually rebalance your
portfolio.
Here’s how it’s supposed to work. First, you initially construct a
portfolio that is made up of the various asset classes, such as large
company stocks, small company stocks, various bonds, real estate investment
trusts, international stocks, etc. Next, you determine the best weighting
(allocation) to give each of these asset classes. Then once a year, you
sell the profits from your winners and use that money to buy more of your
losers, to bring everything back into balance with your original allocation.
The idea is to force self-discipline by buying into depressed sectors that
may be due for a rebound, while lightening up on high-flying sectors that
could be set to tumble. It’s called portfolio rebalancing.
I agree that it is important to diversify your portfolio with
multiple asset classes and especially with different investment strategies.
And I agree that it is a good idea to rebalance the portfolio periodically.
The Hardest Part: Deciding On The Investments
The problem I have with so many of these investment articles in the
financial press is that they assume their readers already know how to
allocate their portfolios; they know which asset classes are appropriate for
them; and they know what percentages should be allocated to each asset class
and/or strategy.
Yet our many years of experience tells us just the opposite, that most
investors don’t really know these things. Most investors need a
professional to help them with these decisions. They need a professional
financial plan designed specifically for their needs, risk tolerance and
financial objectives.
I wish the press would stop telling individual investors that they can do
all these complicated things on their own. The press should be advising
them to seek professional help in their investment selection and portfolio
management. It’s called financial planning.
At ProFutures Investments, we provide comprehensive financial planning at no
charge. We have three Investor Representatives with years of financial
planning experience, including one Certified Financial Planner.
At no cost or obligation, and based on the information you give us, we will
do a full analysis of your investment portfolio, and we will give you a
formal recommendation including any changes we would suggest.
As noted above, we do believe that diversification is very important - both
in terms of asset classes AND strategies. Where we differ from most
financial planning firms is that, in addition to mutual fund portfolios, we
also have specific managers that bring you different strategies such as
sector rotation, market timing, etc. While not suitable for everyone,
most investors who come to us want to add these strategies and others to
their portfolio.
If you would like to take advantage of the financial planning services we
offer, you need only to give us a call at 800-348-3601 to get
started. There is never any pressure to invest in any of the services we
offer.
At the end of July, the Commerce Department released its preliminary report
on 2Q GDP, showing the economy expanded at an annual rate of 3.0%. That was
somewhat less than the average expectation of 3.5%. On June 25, the
government released its final report on 1Q gross domestic product. In that
report, they revised 1Q GDP growth down to 3.9% (annual rate) from 4.4%
reported earlier. That compared to growth of 4.1% in the 4Q of last year.
Keep in mind that growth of 3.9% and 3.0% are both strong, but the reaction
to the latest preliminary report for the 2Q was rather negative. The media,
of course, characterized the latest GDP report as very disappointing and a
sign that the economic recovery is grinding to a halt. Not so, as I will
explain below.
The economic recovery has slowed modestly as indicated by several reports
over the last several weeks. Here's the rundown. The Index of Leading
Economic Indicators edged down 0.2% in June (latest data available), the
first monthly decline since March 2003. While some in the media made a big
deal out of this, the LEI is still above where it was in the 1Q of this
year. We would have to see this index fall for three consecutive months to
indicate that the economy is in any trouble.
Consumer spending slowed slightly in June with retail sales falling 1.1%.
Here, too, a modest decrease in one month does not suggest a trend.
Durable goods orders declined by 1.8% in May, and the media made a big deal
about that, yet orders for non-durable goods rose by 1.5% the same month.
Durable goods orders rebounded, up 0.7%, in June.
The Institute for Supply Management's ISM Index fell from 65.2 to 59.9 in
June, the lowest level since December. The index had risen sharply for
several months in a row, hitting a record high in April, so it is not
unusual to see a pullback. Keep in mind that any reading above 50 indicates
that the economy is growing. Here, too, we would have to see this index
fall for three consecutive months to suggest that the economic recovery is
stalling.
Not All Bad News
The media has a tendency to focus on the bad news. Yet there have been
several very positive reports over the last few weeks that you may not have
heard about. Perhaps the most encouraging is the Consumer Confidence Index
which soared almost 9 points in June to 101.9, the highest level since June
2002. Separately, the University of Michigan's consumer sentiment index
also rose sharply in June. The Consumer Confidence Index for July was
released last week showing another jump of over 3 points to the highest
level in two years. This is important because consumer spending accounts
for apprx. 70% of GDP.
Sales of existing homes hit a new record high of 6.95 million units in June,
despite higher mortgage rates. New home sales hit a record in May. So, the
housing market remains very robust even in the face of higher interest
rates.
While the media made a big deal out of the latest jobs report, there are
indications that hiring will increase in the months ahead. The Labor
Department reported that 112,000 new jobs were created in June, versus
250,000 in May. Even though the July unemployment number was very
disappointing, over one million new jobs have been created this year, and
there are indications that new job creation will increase in the months
ahead.
The National Association for Business Economics conducts a quarterly hiring
survey of CEOs of major corporations. In the latest survey, 41% of
respondents said they plan to increase hiring versus only 34% in the last
survey taken in March. This suggests that the rate of new job creation will
increase in the second half of this year.
Finally, the latest Wall Street Journal survey of economic forecasters is
very encouraging. The Journal surveyed 55 leading economists earlier this
month, asking for their predictions on economic growth. The average
estimate is for GDP to grow by 4.4% in the 2Q and 3Q and 4.2% in the 4Q.
They also predict growth of 3.7% in the first half of 2005.
So The Economy Is Fine
Despite how the media and the gloom-and-doom crowd may spin it, the US
economy remains on very firm ground. Solid growth should continue through
the end of this year and well into 2005, barring some major unexpected
surprise.
Obviously, if there is another major terrorist attack in the US, then we can
throw these positive forecasts out the window. As discussed further on
pages 5 and 6, we have all heard the new terror warnings which were
announced on August 1, complete with specific targets the terrorists may
have (or had) in mind. Unfortunately, it is impossible to know if these
threats are real. But other than this risk, the economy will continue to
grow.
The Impact Of High Oil Prices On The Economy
As this is written, crude oil has just soared to a new record high above
$44.50 per barrel. Skyrocketing oil prices have obviously played a role in
slowing the economy down somewhat, as discussed above, but not by nearly as
much as the media and the Democrats would have us believe.
With oil prices rising almost daily, we have seen the usual outpouring of
pessimism from the gloom-and-doom crowd, the media and the Democrats. The
media and the Democrats would have us believe that the spike in gasoline
prices is all the fault of George W. Bush and his former cronies in the oil
business. The truth is, US presidents have very little influence on oil
prices, even if they resort to tapping the strategic oil reserve.
In their July issue, the editors at The Bank Credit Analyst offered
the following analysis which suggests that high oil prices are not nearly as
big a drag on the economy as the media and the Democrats would have us
believe. They say:
“High oil prices have caused problems in energy-intensive sectors of
the economy. Nevertheless, prices have not been high enough to threaten the
overall economic recovery. It is often pointed out that previous spikes in
oil above $30 caused economic downturns. However, there are important
differences between the current environment and other periods when oil
prices rose sharply.
For example, in the previous episodes, the economic expansion was
already at a very advanced stage. Monetary policy was tight with the yield
curve either flat or inverted and the economy was running out of steam.
Thus, oil prices moved up when the economy was already very vulnerable. The
same point holds true whether one looks at indicators for the U.S. or the
global economy.
It is also very important to remember that the U.S. and other major
economies have become less sensitive to oil price movements over the years
because of increased energy efficiency. This shows up in the steady decline
in the amounts of energy and oil that are required to produce a dollar of
GDP. The ratio of oil consumption to GDP has fallen by over 50% in the past
30 years.
The same picture is broadly true for other industrialized economies.
The reduced sensitivity to oil is also highlighted by the fact that oil
accounted for only 3% of consumer spending in the first quarter, compared to
4% at the time of the 1990 Gulf War and 6% two decades ago. Higher oil has
taken a bite out of consumer spending power, but the effect has not been
large. The bottom line is that as long as prices don’t keep rising, the
impact on overall economic activity should be modest.
The impact of higher oil prices on consumers is probably more
psychological than real. For example, there has been much talk about the
effect of higher gasoline prices on summer vacation road trips. Yet,
assuming a road trip of 1500 miles, the increased cost of a rise from $1.50
to $2.00 a gallon is only about $37. That hardly seems a vacation killer.
In a similar vein, the difference in the annual running costs between
a family sedan and a SUV is only about $150 for each 50-cent increase in the
gasoline price (assumes 11,000 miles a year). Rising gasoline prices perhaps
have an exaggerated impact on confidence because it is a highly visible
price and most drivers have to buy gas every week.”
In addition to concerns about the impact of high gasoline prices on consumer
spending, there is also the valid concern about what soaring oil prices mean
for inflation and thus, Fed monetary policy. The editors at BCA address
this concern as follows:
“This is where it is important to distinguish between relative and
absolute price changes. If the Fed is maintaining a steady monetary policy,
then a rise in the price of oil should not lead to a generalized inflation.
In that sense, higher oil prices represent a relative price shock. However,
if the Fed is more concerned with supporting growth than controlling
inflation and accommodates the rise in oil prices, then the odds are good
that the overall inflation rate will move higher.
The Fed made the mistake of accommodating the early-1970s oil shock
and this shows up in the strong pass-through from higher oil prices into
core inflation. By the time of the second oil shock at the start of the
1980s, the Fed had just launched its major attack on inflation, but the new
policy stance was still at too early a stage to prevent the surge in oil
from feeding into overall prices. However, subsequent jumps in oil prices
(1990 & 2000) had limited impact because of the Fed’s anti-inflation stance.
There could be a bit more of a passthough in the current cycle because
the Fed is running a very accommodative policy. Core inflation has increased
in recent months and higher energy prices may be partly responsible.
Corporate pricing power has improved and companies will pass on the
increased cost of oil if they are able. Nonetheless, the odds of a sustained
acceleration in inflation are low.”
Where Oil Prices Go From Here
Over a year ago, when crude prices were trading near $25 per barrel, the
editors at BCA predicted that prices would increase to a new trading range
of $30-$35 dollars per barrel. They accurately predicted the economic
recovery and a surge in global energy demand. Their forecast was right on
track, as usual, except that oil prices are now considerably higher than
they predicted. On this, they say:
“It does not seem credible that supply and demand trends have changed
enough since the end of last year to warrant an almost $10 jump in prices.
Indeed, the recent run-up in prices above $40 had all the classic hallmarks
of a speculative overshoot... There will be some relief on the supply side
with OPEC announcing that production will be raised by 2.5 million barrels a
day. Modest increases in global oil output and a reduction in speculative
activity should be enough to reduce prices to the low $30s.”
BCA’s analysis indicates that high oil prices are not nearly the drag on the
economy that we are led to believe by the media. BCA was careful not to
speculate on how high oil might go before it peaks, or when it will peak,
but they do not believe it will remain at current levels for an extended
period of time. We have to hope BCA is right on this one, that this is a
speculative overshoot and that prices will fall back to the $30-$35 range
before too long.
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