LOOKING BACK & LOOKING FORWARD

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
December 23, 2003

IN THIS ISSUE:

1. Economic Outlook For 2004.

2. Stock Markets Still Have Upside.

3. Most Bonds Will Under-perform.

4. Wishing You A Merry Christmas.

Introduction – An Eventful Year

As we come to the close of 2003, we have the ability to look back in retrospect on a truly eventful year. We have seen the United Nations teeter on the border of global irrelevance, long-standing international relationships redefined, a war waged and won, a despot captured, and a resurgence in the economy and the stock markets.

It is truly difficult to look back to any other single year in the history of America and find so many major issues dealt with over a twelve-month period of time. However, this is exactly what happened in 2003. Obviously, not all issues have been totally resolved, but I think we are certainly closer to the end than to the beginning.

My job, as a writer and observer of economics, investments and politics, is to try to make sense of all of these things, and relate how they are likely to affect your investments in 2004 and beyond. Believe me, this is no small task.

In this issue of the Forecasts & Trends E-Letter, I will discuss the most important issues of 2003, and how they are likely to affect your investments in the future. I’ll also take a look at some calls we made during the year, and how they came out.

Politics

With the capture of Saddam Hussein, the continued improvement in the economy and the suicidal shift to the far left by the Democratic Party, I have a hard time seeing anything but re-election for President Bush. These events, not all of them controllable by Bush, came together to his advantage and as a politician, he’s certainly going to make hay while the sun is shining on his campaign.

However, not being one to count on the capture of Hussein or the absence of another terrorist attack on the U.S., Bush and his handlers have also taken some of their own steps to position for re-election. Some of these steps, such as the ban on partial-birth abortions, have been in line with conservative values. Others, however, have involved either abandoning or seriously compromising traditional conservative positions.

For example, the steel tariffs, the farm bill, and even the prescription drug bill are viewed by hardcore conservatives as Bush’s willingness to dance with the Devil, so to speak, to gain the political upper hand. To some extent, he has taken a page from Bill Clinton’s playbook by usurping traditional Democratic issues and claiming them for the Republicans. But at what cost?

I believe that Karl Rove and Bush’s other top advisors looked at the political landscape and decided, there’s no one else out there that the hardcore conservatives would vote for, so why not go after some Democratic issues to try and lock down the swing voters.

While I don’t agree with some of the moves Bush has made for political purposes, let me make it clear that I stand 100% behind the President when it comes to his excellent leadership following 9/11, including the wars in Afghanistan and Iraq. I think America, and the world to a certain extent, are safer now than before.

As a practical matter, with the election coming up in 2004, I don’t see much chance of further compromise with the Democrats. I think this will translate to further stability in the economy and the markets, as I will discuss further below. Of course, I always have to add a caveat in case of another serious terrorist attack on U.S. soil. If that happens, all bets are off.

The Economy

Throughout the year, my best sources have indicated that we would not fall back into a “double-dip” recession, that we would not enter a deflationary spiral and that the U.S. economy would “surprise on the upside.” As we look back upon 2003, we find that my trusted sources were once again correct. The only missing ingredient was an increase in jobs, and even that is beginning to improve.

Looking forward to 2004, these same sources are saying the economic recovery will continue, and employers will increase hiring as they become more certain that the economic recovery has legs. In reality, we are already very close to what economists call “full employment.” Most economists agree that full employment is somewhere between 4% and 6%, so the current unemployment rate of 5.9% is not so bad, despite what the media says. And it should get even better in 2004.

Not the least among those factors responsible for the recovery has been the Federal Reserve’s action to keep interest rates low and thus liquidity high. Low interest rates have led to refinancing higher interest debt, thus freeing up money for consumption. In addition, higher real estate values allowed consumers to borrow against their home equity at low rates to consolidate debts and purchase needed items. All of this consumer activity helped to fuel the recovery.

However, the Fed’s easy money policy has also had its fair share of critics over the year. Analysts say that the increased level of personal debt has put consumers in a bad situation should interest rates rise, which they are sure to do as the economy heats up. In addition, weak businesses that may have called it quits during periods of higher interest rates were able to borrow at low rates, thus prolonging the inevitable. Finally, many analysts are very concerned about the soaring federal deficit, especially in light of the new Medicare prescription drug plan that will cost hundreds of billions of dollars over the next decade.

While I’m not a gloom-and-doomer, I do feel that these arguments have some merit. As I have written in previous weeks, editors of The Bank Credit Analyst, though convinced of a continued economic recovery in 2004, warn that the high levels of debt cannot go on forever. They predict that a day of reckoning will come, most likely when we hit the next recession, and that it will be ugly.

Having said that, they do not believe (and neither do I) that this reckoning will come in 2004, barring a major negative surprise. But in 2005 or 2006, things could be different. One reason that the next recession is predicted to be so bad is that the Fed essentially used all of its “bullets” in the form of interest rate reductions for the most recent recession. With short-term interest rates now standing at 1%, there’s not much further down they can go.

To “reload,” the Fed would have to have a considerable period of time where the economy does well, and during which they can raise interest rates up to a more normal level of 4% to 5%. With Chairman Greenspan’s recent statements that interest rates will be held low for a considerable period of time, it is unlikely that much reloading will occur any time soon.

Even when the Fed does start raising interest rates, I look for it to be a slow, gradual process, exactly the opposite of the drastic reduction in rates we saw in 2000. Raising rates too quickly could result in stalling the economic recovery, and that won’t happen during an election year, my friends.

So, the word for 2004 is, enjoy the economic expansion while it lasts. My advice would be to get your personal balance sheets in order. That means pay off debt, especially any with variable interest rates that can go up, while the rates are still low and resist the temptation to incur new debt.

Stock and Bond Markets

If you took my advice in March and got fully back in the stock market before the war started, you have enjoyed a spectacular ride. If you did not, then you have missed a lot of the upside, but you may still have some time to get in on the action. However, what I said above about improvement in the economy may not entirely translate into the same level of gain in the stock markets.

There is a common misconception that the stock market must mirror the overall economy. While it is accurate to say that the stock markets tend to do better when the economy is growing, it is not true all of the time. The stock markets are influenced by a number of key factors, only one of which is the economy.

In my opinion, the 2004 stock market probably is not likely to match the gains of 2003. The Dow and the S&P 500 are both up well over 20% this year, while the Nasdaq is up over 45% as this is written. One reason I say that the markets probably won’t match their 2003 gains is that corporate profits need to catch up to the high expectations already priced into the market. I must admit, however, that this is a widely-held view for 2004.

Given that, the stock markets could continue to surprise on the upside. There is still a ton of money on the sidelines, and when the year-end performance numbers come out, investors are going to see, once again, that they missed out on gains of over 20% (if the current gains hold up). Many of these investors will feel like we’re back in the good old days of the late 1990’s when the S&P 500 Index could be expected to gain 20% or more per year. Money will flow into the market from the sidelines, creating an upward pressure on prices and producing a self-fulfilling prophecy. The higher the market goes, the more money will leave the sidelines, creating even higher prices.

Mutual funds, who are already touting big year-to-date returns, are also going to shift into high gear advertising mode once they have a 2003 calendar-year performance in the 20% or better range. This could lead to a feeding frenzy.

My advice is to enjoy the party while it lasts, but realize that it can quickly come to an end, just as it did in 2000. If you are already invested in stocks, I would stay the course. If you did not get into the stock market in 2003, I still think you have some upside potential in 2004, but I don’t bank on another 20%+ year.

Those of you who have been in the market and enjoyed the gains of 2003 certainly don’t want to give it all back in a major correction. And investors who are still on the sideline don’t want to buy in at the peak, only to see their principal significantly eroded. Either way, I will repeat the advice I have given over and over during the year: Most investors would probably be better off using a professional Advisor rather than trying to determine when to enter and exit the market on their own.

The Outlook For Bonds

As I warned continuously in the early months of this year, Treasury bonds as well as high-grade corporate bonds were overdue for a major correction. The continued economic recovery, coupled with the potential for higher interest rates, will continue to exert downward pressure on these investments.

If you are currently heavily invested in high-grade corporate bonds or Treasuries, I would advise you to reduce positions. If you’ve been invested in these instruments for the last few years during the bear market in stocks, you should still have some profits. Taking part of your money off the table now will lock in these profits. If you got into bonds late in the party, and you now have losses, I would still lighten-up and limit further losses.

While Treasuries and high-grade corporate bonds look weak for 2004, high-yield (junk) bonds continue to look strong. That’s because high-yield bonds traditionally lead out of a recession. As the economic recovery continues, I expect high-yield bonds to continue to do well. I do not expect as much upside potential for 2004 as we saw in 2003 (the CSFB High-Yield Bond Index is up over 25% year-to-date as of November 30). However, I think there is still enough gain potential to make high-yield bonds an attractive investment in the year ahead, especially if you use highly diversified funds that invest in these instruments.

As you will recall, I have repeatedly recommended Capital Management Group’s high-yield bond programs as an alternative to traditional bond holdings. I believe CMG’s bond programs are superior to buying individual bonds or bond funds in that CMG will move into and out of the market as the market environment dictates. This offers investors the potential to participate in gains during up periods, and sit on the sidelines in down markets. CMG had an outstanding year in 2003. (Past results are not necessarily indicative of future results.)

Wishing You A Merry Christmas

While it is the practice of many of my contemporaries to call this time of the year the “Holiday Season” or some other politically correct name so as not to dismay those who pretend to be offended just by the mention of anything concerning Christ, I will not do so. This holiday is intended to celebrate the birth of the Christ Child, a rare and wondrous occasion, and I embrace it for all of its meaning.

I will not apologize for celebrating the birth of Christ any more than I would expect my Jewish friends to apologize for celebrating Hanukkah, or my Muslim friends for celebrating Ramadan, or even atheists for just thinking it’s nothing more than the traditional time to give and receive gifts every year.

After all, Jesus taught us that God loved us enough to show us an example of sacrificial love, so that we should strive for peace, and love each other as much as we love ourselves. So far, I have never found anyone from any religion who can argue with these principles.

So, this Christmas I wish you the best that this time of year has to offer. I hope you are able to enjoy being with family and friends during the holidays, and that you take time from your busy holiday schedule to remember the Reason for the Season.

Season’s greetings,

Gary D. Halbert

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