BCA’S ECONOMIC FORECAST & GORE’S REVENGE

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
December 9, 2003

IN THIS ISSUE:

1. The Bank Credit Analyst Is Upbeat About Economy In 2004.

2. BCA Also Believes That Stocks Will Be Higher Next Year.

3. Al Gore’s Revenge – Former VP Throws Support To Dean.

4. The Real Reason Gore Did This (*Don’t Miss This One*)

Introduction

As an investment professional, I read many research publications and subscribe to various groups that provide economic and financial forecasts. For the last 25 years, the research group I have found to be most accurate at forecasting major trends in the economy and the major investment markets is The Bank Credit Analyst. While BCA is a very expensive publication, I have found it invaluable over the years.

This week, I will share with you BCA’s latest forecast for 2004. As you will see, they are optimistic that the economy will continue to expand for the next year. You will also see why they believe the Fed is running scared and what they expect for interest rates in the next year. And you will read why BCA is optimistic about the stock markets for the next year as well.

Last but not least, Al Gore shocked politicos on both sides of the aisle by endorsing Howard Dean for president. Everyone is asking, why would he do this? I’ll tell you why. This is Gore’s revenge against the Clintons. But that’s not the whole story. My take on Gore’s latest move and his ultimate motive is at the end of this E-Letter.

BCA On The Economy

The following is excerpted from the December issue of The Bank Credit Analyst:

QUOTE: “The foundations under the U.S. economy are getting stronger. The corporate sector is emerging from its severe retrenchment, thereby reducing the economy’s dependence on continued strong growth in consumer spending. With demand becoming more balanced, there is less need for major policy stimulus, and the odds are good that the economy will continue to deliver positive surprises in the coming year.

The Federal Reserve is taking nothing on trust. The Fed’s base case is that the economy will grow at a decent pace next year, but it does not have a huge degree of confidence in this forecast. The Fed has thus made it clear that it will retreat only slowly from its current highly stimulative stance.

The maintenance of abnormally low interest rates will substantially boost the prospect of solid economic growth, and will foster continued risk-taking by investors. Equities [stocks] should keep outpacing both bonds and cash in 2004, even though the absolute gains from stocks will likely fall short of those achieved this year…

It is sometimes argued that the Fed has seriously erred by easing policy so aggressively during the past couple of years. The sharp drop in interest rates encouraged consumers to take on more leverage rather than retrench [by increasing saving], and also stopped the equity bubble from fully deflating.

There is no doubt that keeping the fed funds rate at 1% has created financial distortions and has fueled speculation. However, the Fed has explicitly wanted to encourage more risk-taking, to counter the retrenchment that normally occurs in the wake of a burst asset bubble [the stock markets]. The Fed was not able to prevent a deep cutback in corporate sector spending, which made it all the more important to prop up consumers.

After the bubble burst, the corporate sector suffered the worst downturn in profits since the 1930s. If the Fed had not taken aggressive action to boost housing and consumer spending, the squeeze on the corporate sector would have been even more severe, which would have fed back into even weaker employment. The end result could have been a self-feeding downward spiral of economic activity and asset prices, presumably triggering a full-fledged debt deflation...

What the BCA editors are saying here is that if the Fed had not moved so aggressively to slash interest rates, the recession would have been much deeper and might possibly have worsened into a depression. They continue:

The Fed’s policy has not been costless. By encouraging the consumer sector to take on more leverage rather than rebuild savings, the Fed has raised the stakes for the next downturn. The downside risks in the next recession may be much greater than they would otherwise have been, because of increased debt levels. However, the Fed decided that it was worth trading almost certain disaster in the recent cycle for a potential threat at some point in the future.

The same argument can be made for fiscal policy. The Administration [with willing accomplices in both parties, I might add] has been responsible for turning a large structural fiscal surplus into a large deficit, with possible serious long-term consequences. Nonetheless, tax cuts played an important role in supporting the consumer at a time when the corporate sector was engaged in a vicious retrenchment...

One might reasonably have expected a very deep recession given the bursting of one of the greatest asset bubbles in history, the shock of September 2001, the rash of corporate scandals, and high energy prices. The fact that the U.S. suffered the mildest downturn on record is testimony to the power of the massive stimulus thrown at the economy.

Even so, the economy skirted dangerously close to deflation, and the Fed is not convinced that the danger period has ended... The Fed has lost confidence in its own and everyone else’s economic forecasts. The Fed’s economic models did not work very well during the past couple of years.” END QUOTE

What the BCA editors are saying here is that the economy’s near-miss with deflation during the recession basically scared the pants off Alan Greenspan and the Fed governors. In response, they overreacted and will probably not breathe a sigh of relief until they see the inflation rate begin to inch higher. In doing so, they not only managed to avert deflation but they significantly softened the recession, and now we find ourselves in a roaring economy. Of course, as BCA pointed out, this has resulted in higher debt levels and much greater risks whenever the next recession comes along.

When Will Rates Go Up?

This, then, brings us to the question, when will the Fed begin to raise interest rates again? The Fed knows that a 1% Fed funds rate is too low and will eventually need to be raised to between 4% and 5%, a level that is consistent with the growth rate of the economy. The Fed also knows that the longer rates stay at 1%, the more problematic the higher interest rate adjustment will be for the stock and bond markets. They likewise know that leverage and debt levels will continue to build as long as rates remain extremely low. Nevertheless, these are regarded as minor problems compared to those associated with raising rates too soon. The Fed wants to make sure deflation is dead, at least for this cycle. Thus, the bottom line is that the Fed feels under no pressure to change its stance just yet.

Following the late October Fed policy meeting, Greenspan stated that it is the Fed’s intention to hold rates at these low levels for a “considerable period.” As usual, no one knows how long that might be. The latest strong economic news has led many to suggest that the Fed may begin raising rates any day now. However, BCA believes that the Fed will insist on seeing “sustained strength in the labor market (several months of at least 150,000 job gains),” and clearer signs that the threat of deflation has passed.

Thus, BCA makes the case that any such rate increases won’t begin until next spring, or maybe even the middle of next year. And they believe that the Fed will move slowly when they do start to move.

BCA believes that the next move by the Fed will be the dropping of the “considerable period” (before rates are increased) language, and thus leave it open as to when rates will be increased. That could possibly occur as soon as the December Fed policy meeting which is underway as this is written. If the language is changed, I don’t believe that will have any significant negative effect on the markets, since many analysts are thinking that the latest strong economic news could lead to a small rate increase very soon.

Will Rate Hikes Hurt Stocks?

As discussed above, it is BCA’s position that the rate hikes won’t begin until next year, specifically in the 2Q at the earliest, and the increases should come slowly and in small increments. Unless rates have to be hiked in a more rapid manner, BCA believes stocks will continue to do relatively well. They believe that stocks will be even higher in a year than they are today. As a result, BCA continues to advise investors to maintain a fully invested position in stocks. Here is BCA’s argument for stocks and/or mutual funds:

QUOTE: “The equity market has marked time in the past month, despite a strong showing from the economy and corporate earnings. The market had been overbought following earlier gains, and geopolitical concerns and mutual fund scandals have weighed on investor sentiment. Equity prices may have also been held back by a desire to lock in gains before the end of the year. Nevertheless, the cyclical bull market remains intact, with the major indexes holding above their rising 200-day moving averages.

The case for equity prices rests on the following:

[1] The negligible level of short-term interest rates provides a powerful inducement to seek higher returns in stocks. This is especially true given the huge stockpile of cash sitting in retail money market funds and savings deposits. Investors should become more comfortable taking on extra risk as their confidence in the economy improves.

[2] Valuations are reasonable with the S&P 500 trading at around 17 times forward operating earnings. With earnings expected to rise by at least 10% next year, equity prices will rise even if multiples stay constant.

The bears have been frustrated by the fact that the market never became compellingly cheap as would have been expected following the bursting of the bubble. In past bear markets, the price/earnings ratio (based on forward operating earnings) dropped to 12 or less. This time, it never fell below 15. However, by slashing interest rates aggressively, the Fed was deliberately trying to prevent a complete market washout, and its policy was successful. The market has long since passed the maximum danger point, and a major relapse would only occur in the context of a major event [surprise] that shocked confidence and triggered a renewed slump in the economy. The probability and timing of such an event is impossible to predict.

This does not mean that the market will not suffer periodic setbacks. For example, the optimistic level of investor sentiment warns that the market is still a bit overextended. However, this can be unwound with a sideways move rather than a large drop in prices.

On balance, we continue to recommend above-average weightings in equities. The gains during the coming year seem likely to fall short of those achieved in 2003, but the potential exists for the market to exceed expectations once again.” END QUOTE

[To subscribe to BCA, visit their website at www.bcaresearch.com or call them at 514-499-9706. I highly recommend it.]

BCA’s views on stock market returns over the next year are consistent with those of several other respected analysts. I happen to agree with this view. However, with stocks having risen significantly already, I continue to believe that most investors would be well served to have professional Advisors managing a good portion of their equity investments, and specifically those Advisors that can move to the safety of a money market fund should conditions change.

For information on the two professional money managers I have recommended most often this year, CLICK HERE.

LATE BREAKING NEWS:
Al Gore’s Revenge – Bye, Bye Clintons?

On Tuesday morning, Al Gore shocked politicos on both sides of the aisle by endorsing Howard Dean for the Democratic presidential nomination. Political analysts are still scratching their heads as to why Gore would come out of near seclusion to support Dean who is clearly the most liberal of all the Democratic presidential wannabes. With Gore’s support, Howard Dean is now a bona fide “juggernaut” with a virtual lock on the nomination.

People everywhere are asking why Gore would do this. What’s in it for him? He’s not running for anything. He wouldn’t want a step-down cabinet position in a Dean administration. He wouldn’t want to be Dean’s VP. Does he really even believe that Dean can win? Or, is he doing this just to get in the fight against his old rival, George W. Bush? I don’t think so. Here is my take on why Gore suddenly decided to throw his considerable support behind Howard Dean.

This is about Gore making a move to take control of the Democratic party away from the Clintons. Plain and simple, that’s what this is all about. Gore knows Dean is not likely to win in 2004, but if he gets the nomination, the Clintons and DNC chief Terry McAuliffe are out of power and out of control of the party, finally.

Many of you, no doubt, will disagree (and I’ll get hundreds of responses accordingly). But first consider this. Al Gore’s endorsement did not come without a price! That price might very well have been that Dean promised to give Gore defacto control over the DNC. And why not let Gore choose the next head of the DNC, which of course will be one of Gore’s cronies? That seems like a reasonable price for Dean to pay.

But then you ask, why would Gore want to control the party? After all, we all know what he really wants is to be president. Well, think about it. To do so, we have to go back and remember that there was no love lost between Gore and the Clintons. Remember how Gore tried to distance himself from the Clintons until the very late stages of his presidential run against Bush? Gore did not want to be associated with all the dirty laundry surrounding the Clintons.

The bottom line here, in my opinion, is that Gore sees this as an opportunity to take control of the Democratic party away from the Clintons. It is well known that Dean does not like the Clintons, and he has made it known that if he gets the nomination, Terry McAuliffe (the Clintons’ handpicked chairman) is OUT at the DNC. Gore’s revenge!

Too far fetched? Maybe, but I don’t think so. Follow me through this scenario. Gore knows Dean isn’t likely to win. But Gore supports him anyway, for the reasons noted above. Dean gets the nomination, McAuliffe is canned at the DNC and Gore gets to hand-pick his successor. Then Dean loses and immediately vanishes from the political scene. Now you will ask, so what good has that done for Gore? Good question.

Now for the clincher. Everyone knows Hillary plans to run for president in 2008. But if Gore is in charge of the party, by way of his man running the DNC, Hillary’s chances of getting the nomination in 2008 are greatly diminished. Is that Gore’s revenge? Partly, but……

Gore May Be Preparing To Run In 2008

At this point, you either think I’m off my rocker, or that I might just be onto something here. Either way, if you’ve followed me this far, let’s move to the final act.

For whatever reasons, Gore has been laying low for the last few years, probably knowing that if he were ever to have another shot at the White House, he needed to basically disappear from the scene for a while. Now, he re-emerges in eye-popping fashion.

Gore may not only believe that he can steal control of the party from the Clintons, but that he can also lay the groundwork for his own presidential run in 2008. Stranger things have happened!

We know that Gore would still like to be president. We know that Gore doesn’t want Hillary to get the nomination in 2008. We also know there’s no one in the current Democratic field that could stop her. Except maybe Gore himself, but only if he gets control of the party apparatus, the DNC.

Call me crazy if you want, but I wouldn’t rule it out!

Season’s greetings,

Gary D. Halbert

SPECIAL ARTICLES

Dick Morris on why Gore is backing Dean.

How Dean could win (let’s hope not).

Dean, the mysterious stranger.