On The Economy, The Fed & Where To Invest Now

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
December 12, 2006

IN THIS ISSUE:

1. The Economy – The Slowdown Continues

2. Housing Market Continues To Suffer, But No Bust

3. Bernanke Threatens To Raise Rates Again

4. Stocks – Can The Bull Market Continue?

5. Conclusions & What To Do Now

6. Year-end Reminders, Etc.

Introduction

Over the last month or so, we’ve seen numerous economic reports that have been on the negative side. As a result, it seems that more and more forecasters are now predicting a recession for at least the first half of 2007 if not longer. Yet as I will point out below, some of the most important economic indicators remain positive, such as the employment rate which remains strong and the latest 3Q GDP report which was revised upward in late November.

As a result, our friends at The Bank Credit Analyst continue to believe that a recession is not the most likely scenario for 2007, and that a “soft landing" will be achieved. Furthermore, BCA predicts that the US economy will rebound nicely in the second half of next year. Of course, as always, the gloom-and-doom crowd is predicting that we are about to fall off the economic cliff into a deep recession or worse. What else is new?

The Fed Open Market Committee has voted to leave short-term interest rates unchanged at each of its policy meetings for the last three months. As a result, most market analysts have come to believe that the Fed will begin to lower rates in the months ahead, perhaps as early as the latest FOMC meeting which is happening today.

Yet to the surprise of just about everyone, Fed chairman Ben Bernanke announced last week that he is still concerned about the inflation rate, and that the Fed may indeed raise rates rather than lower them in the weeks or months just ahead. This was not the news the markets were looking for. However, as I will explain below, this is probably just tough talk on the part of the new Fed chairman who is trying to establish his credibility, and I continue to believe the Fed will lower interest rates next year.

The stock markets remain very strong, with the Dow Jones near its recent record high as this is written. Despite the election victory for the Democrats, despite the latest negative economic reports, and despite Bernanke’s latest threat to raise rates, stocks just keep going higher. This does not suggest an economy that’s in serious trouble or about to go into a recession or worse as the gloom-and-doomers promise.

The most likely scenario, as BCA suggests, is that the economy remains sluggish for another 3-6 months with no recession, and then rebounds in the second half of next year. Inflation should continue to moderate, in which case the Fed should be able to begin to lower interest rates, perhaps as early as their January 30/31 FOMC meeting. And stocks are likely to continue to move higher next year.

Given this outlook, the obvious question is, how and where do you invest now? Based on comments I receive from readers of this E-Letter, many of you are on the sidelines or are under-invested in stocks and equity mutual funds due to all the uncertainties. Some of you have been under-invested for several years now and have not taken advantage of my advice to the contrary and have not participated in the equity bull market of the last few years.

Thus, my advice is that you take a serious look at the professional money managers I recommend and at our “Absolute Return Portfolios” offered by my company. Our Absolute Return Portfolios are groups of carefully selected mutual funds that have delivered consistent positive returns in both up and down markets in recent years. We have three different portfolios of funds, ranging from moderate to more aggressive, but all three are very attractive. While past results are no guarantee of future results, I believe that one of our Absolute Return Portfolios should be a good choice for most readers of this E-Letter. You should call us today for more information.

With that Introduction, it is clear we have a lot on our plate this week, so let’s get started.

The Economy – The Slowdown Continues

Most of the economic reports over the last month or so have been negative, which is indicative of an economy that is slowing down. Yet despite the latest negative reports, there is no indication we are headed for a recession. In fact, the Commerce Department revised its estimate of 3Q GDP upward to 2.2% (annual rate) from the advance estimate of only 1.6%. The 3Q increase followed 2.6% in the 2Q and 5.6% in the 1Q of this year. Also, the Index of Leading Economic Indicators (LEI) rose 0.2% in October after falling slightly over the previous four months.

The data above are consistent with my forecasts all year, and those of BCA, that the US economy was headed for a mild slowdown but not a recession, assuming there are no major negative shocks. The negative economic reports of late are simply confirming this outlook, as we would expect.

Here are some of the latest economic reports. Durable goods orders fell 8.3% in October (latest data available). Factory orders fell 4.7% and construction spending dropped 1.0% in October. The closely watched ISM manufacturing index fell from 51.2 in October to 49.5 in November; a reading below 50 in the ISM index indicates that the economy is contracting.

The unemployment rate edged up from 4.4% in October to 4.5% in November. Service sector jobs continued to increase last month, while construction and manufacturing jobs decreased – as you would expect from the numbers in the previous paragraph. Still, an unemployment rate of only 4.5% represents an economy that is inherently solid and not likely headed into a recession.

Consumer confidence declined in October and November and looks to be down again in December. The Consumer Confidence Index fell to 102.9 in November, down from its peak of 110 in April, and the University of Michigan’s Consumer Sentiment Index fell from 92.1 in late November to 90.2 in the first week of this month.

While the confidence indexes are down recently, you wouldn’t know it by looking at the latest retail sales statistics. ShopperTrak.com reports that retail sales rose 4.8% in November as compared to last year, and that sales for the first week of December were up 3.0% over the same period last year. So, while consumers report that confidence is down, they’re still spending like crazy for the holidays and standing in long lines (even camping out) to buy hot new products like the PlayStation 3, along with MP-3 players, laptops, camera phones and other popular items. Again, this does not suggest an economy headed into a recession.

Housing Market Continues To Suffer, But No Bust

The slump in housing continues to represent the greatest threat to the US economy, and the latest reports are not encouraging, although not all the news has been bad. Housing starts fell 14.7% in October (latest data available) and are down over 27% from yearago levels. Building permits were off 6.7% in October. New home sales fell 3.2% in October, with the median price falling slightly to $248,500. The unsold inventory of new homes is estimated at 558,000 or a seven-month supply.

The one bit of good housing news was in sales of existing homes, which rose 0.5% in October. The unsold inventory of existing homes is estimated at 3.85 million units, or a 7.4-month supply. The median price for existing homes dipped slightly for the second month in a row to $221,000. The median price of $221,000 is 3.5% below the level in October 2005.

The slump in housing is not over as some suggested after seeing the modest rise in sales of existing homes in October. Others suggested that the rise in inventories of unsold homes may be peaking, which remains to be seen. Keep in mind that the US housing bubble took years to inflate, and it will probably take at least another year before prices stabilize. The question is, how much more will prices soften?

Homebuilders do whatever they have to do to reduce inventory and free up capital, which includes selling completed homes at big discounts and throwing in lots of extras at no additional cost in the current environment. This puts downward pressures on home prices. But as noted above, the inventory of new homes is apprx. 558,000 versus 3.85 million of unsold existing homes. Existing homes are typically owned by individuals, not homebuilders, and homeowners are generally a lot more patient than builders. This may be a big reason why the housing slump has not turned into a bust.

Bernanke Threatens To Raise Rates Again

After leaving interest rates unchanged at the last three Fed Open Market Committee (FOMC) meetings, there has been a broad consensus that the Fed would begin to lower interest rates early next year, possibly several times in order to stimulate the economy. With the latest negative economic reports and the continued slump in housing, it would seem like a no-brainer for the Fed to lower rates next year.

Yet on Tuesday, November 28, new Fed chairman Ben Bernanke surprised just about everyone when he warned that the Fed might raise interest rates again. In his first policy speech since July, Bernanke warned that economic growth outside of housing and autos is still “solid” and that underlying inflation is still “uncomfortably high.”

He said the choice before the Fed now is whether to raise rates, not cut them. “A failure of inflation to moderate as expected would be especially troubling. Whether further policy action against inflation will be required depends on the incoming data,” Bernanke warned.

On the same day that Bernanke issued his surprisingly hawkish remarks, the president of the Philadelphia Federal Reserve Bank, Charles Plosser, had a similar warning. “There remains some risk that policy is not yet firm enough to ensure a return to price stability over a reasonable time horizon,” he said.

The question is really whether the Fed is simply talking tough, or do they really think rates might have to be raised sometime soon? I think it’s the former. Let’s look at the latest inflation numbers. The Consumer Price Index fell 0.5% in October (latest data available), following a 0.5% drop in September. The CPI is up only 1.3% over the last 12 months ended October. The Producer Price Index (wholesale prices of finished goods) fell 1.6% in October and is also down 1.6% over the last 12 months. The trend in inflation is down.

Yet it is widely believed that the Fed focuses most keenly on the CPI “core rate” of inflation which excludes food and energy prices. The CPI core rate was up 0.1% in October and was up 2.7% for the 12 months ended October. This is the number Bernanke is fixated on. In his speech on November 28, he referred to the 2.7% core rate and noted that inflation at that rate “remains uncomfortably high.”

As noted above, the headline rates of inflation are trending down, and the core rate of the CPI should moderate as well over the next few months. Bernanke should know this. That is another reason I believe he is talking tough, and the Fed will not raise rates just ahead.

Bernanke is also well aware that the slumping housing market could turn into a bust if the economy slows down significantly more. In the same November 28 speech, he noted that the greatest risk to US economic growth is that “the correction in the housing market could turn out to be more severe and widespread.” He even suggested that the inventory of unsold homes on the market is likely even larger that official figures indicate. This does not sound like a man about to recommend that interest rates be hiked again.

The stock and bond markets agree. Stocks rallied strongly for several days after Bernanke’s warning on November 28, and the Dow Jones is back near its record high as this is written. Bonds also rallied after Bernanke’s latest speech. The interest rate futures are still priced for a decline in rates over the next six months. These markets still believe the Fed will cut rates sometime in the first half of next year.

The FOMC is meeting today, and I expect an announcement later this afternoon that the Fed Funds rate has been left unchanged for a fourth consecutive time.

Stocks – Can The Bull Market Continue?

To be perfectly honest, I don’t have a clue what the stock markets will do over the next year. As noted above, BCA predicts that stocks will continue to move higher over the next year. In their latest weekly Investment Bulletin, the BCA editors note:

“For stocks, the market is getting stretched, but still offers good value compared with other assets. The case for a re-rating [higher prices] in equities remains good, although much higher P/E ratios may not develop until the economic slowdown is nearing an end, and investors start to gain conviction in the durability of the economic expansion.”

This is BCA-speak for their forecast that equity prices will continue to trend higher next year. Yet if equity prices do continue to trend higher, as I expect they will, the risks in the market will continue to increase as well. Negative surprises can certainly occur, especially if things go badly in Iraq or elsewhere, or if there are more terrorist attacks. Negative surprises could result in a significant downward correction in equities at these high levels. Even if there are no major negative surprises, market volatility is likely to continue to increase as prices move higher.

Conclusions & What To Do Now

If The Bank Credit Analyst is correct, and they usually are, we are looking at a couple more quarters of slow economic growth but no recession. Inflation should moderate more on the downside. The Fed will likely cut interest rates by a quarter-point a couple of times in the first half of next year, possibly as early as their January 30/31 FOMC meeting. And then we should expect the economy to rebound in the second half of next year.

In the meantime, expect the gloom-and-doom crowd to get even more shrill in their promises of a recession or worse with each and every economic report that is the least bit negative. These people never give up; they missed the bull market of the late 1990s; and they missed the bull market of 2003 to the present. Still, they never give up.

Which brings us to what the rest of us should be doing investment-wise. As noted in the Introduction above, there are many investors who are either still on the sidelines in the equity markets, or have been under-invested for the last several years. With the markets at new recent highs (and the Dow at an all-time record high), many investors cannot bring themselves to get back in at this point. For the record, I am fully invested in equities and have been for the last several years, along with my other investments.

The bulk of my equity portfolio is invested with the professional money managers I recommend to my clients. Most of these successful professionals use sophisticated “active management” strategies that have the flexibility to exit the market (partially or fully) and/or “hedge” long positions should market conditions turn ugly.

In my October 24 E-Letter, I introduced readers to one of my favorite professional money managers, Potomac Fund Management. If you read that E-Letter, you know that Potomac has an excellent performance record, with very modest losing periods, even when stocks are trending lower. While past results are no guarantee of future results, I think most readers of this E-Letter should be well served to consider an investment with Potomac.

Keep in mind that Potomac’s minimum investment requirement is $50,000, but until the end of this year, my clients can still open accounts for only $25,000. In order to take advantage of this opportunity, you must get your account paperwork completed and back to us by the end of the year. So, I recommend you call us today at 800-348-3601 and request more information on Potomac Fund Management.

In my September 12 E-Letter, I wrote about Third Day Advisors LLC. Third Day is a more aggressive strategy than Potomac in that Third Day will occasionally “short” the market during downturns, using specialized mutual funds that go up when the market goes down. Obviously, an aggressive strategy that can short the market is not suitable for all investors. But for sophisticated, well-diversified investors, Third Day may be an excellent choice. Give us a call for more information.

These are only two of the professional money managers we recommend. There are others I have not written about in the E-Letter this year, but are also worthy of your consideration. You can see information on the other managers I recommend at my website.

The balance of my equity portfolio is invested in our Absolute Return Portfolios which I wrote about in detail in my March 7 E-Letter. Our Absolute Return Portfolios consist of 5-6 carefully selected equity mutual funds that have delivered consistently positive returns in up or down markets. While past performance is not necessarily indicative of future results, the returns of the mutual funds in our Absolute Return Portfolios are indeed impressive.

There are three different Absolute Return Portfolios, with risk/reward profiles ranging from moderate to more aggressive. The three portfolios are called “Moderate,” “Moderate-Plus” and “Aggressive.” In somewhat of a surprise, the Moderate portfolio is actually the best performer so far this year.

Clients in our Absolute Return Portfolios establish an account(s) at TD Ameritrade where their funds are held. Once the account is open and funded, we then purchase the mutual funds that are included in the Absolute Return Portfolio you have selected. We monitor the mutual funds and client accounts daily and make any changes we deem necessary along the way. You receive a monthly account statement showing all activity.

I would highly recommend that investors reading this E-Letter take a look at our Absolute Return Portfolios. The minimum required to invest in one of our Absolute Portfolios is only $15,000.

Also, don’t forget to consider “gifting” an investment account to someone you love before the end of the year. I wrote about that at length in my November 21 E-Letter. It’s not too late to get that done before the end of the year. Remember that we are accepting minimum accounts of only $10,000 for our Absolute Return Portfolios if they are in the form of a gift.

Given that the year-end is fast approaching, you should call us at 800-348-3601 to get started.

If you have hesitated to invest with my company because you don’t live in this area, don’t let that stop you. We have clients in all 50 states, most of whom I have never met. In this Internet Age, you may not want to restrict your investment advice only to your local broker or advisor. So don’t let the fact that I’m in Texas and you are somewhere else stop you from taking advantage of the investment programs I recommend.

Reminder: A Stratfor Deal For You

If you’ve read this E-Letter for long, you know I am a big fan of Stratfor.com and Dr. George Friedman, its founder and chief executive officer. Stratfor has been described as a “mini-CIA” with its global intelligence network. They provide a wealth of geopolitical and economic information.

I have negotiated a great subscription deal with Stratfor for those of you who read this E-Letter. For a limited time, you can subscribe to Stratfor’s “Premium” service, which normally costs $349 per year, for only $199 for one year. Or you can subscribe monthly for only $19.99, a 50% discount to their regular price of $39.99. I highly recommend it!

[Please note that we have negotiated this special price from Stratfor as a service to our clients and readers, and we do not share in any of the proceeds.]

CLICK HERE for subscription information and this special offer. Many thanks to George and the good folks at Stratfor for making this offer available to my readers!

“All They’ll Need To Know” Still Available

In recent weeks, I have offered the very valuable booklet entitled “All They’ll Need To Know” which provides a comprehensive set of lists for recording all of your important financial and investment information in one place. It even includes sections for you to record your wishes upon your death, including your funeral arrangement preferences and other instructions for your loved ones to follow upon your death.

The response to this free offer has been overwhelming. We have now sent out thousands of these booklets to clients and readers of this E-Letter! We still have copies of All They’ll Need To Know, so feel free to call and request a copy, or several copies if you have family or friends that could benefit from this very valuable booklet.

Warmest holiday wishes,

Gary D. Halbert

SPECIAL ARTICLES:

Kofi Annan’s classless exit from the UN.
http://www.investors.com/editorial/editorialcontent.asp?secid=1501&status=article&id=250732610175159

A remarkable plot – the poisoning of Litvinenko.
http://www.economist.com/daily/news/displaystory.cfm?story_id=8401580&top_story=1

2008 hopefuls woo Bush clan donors, aides.
http://www.latimes.com/news/politics/la-na-mantle11dec11,0,7194078.story?coll=la-home-headlines

How Barack Obama affects Hillary’s run for the White House.
http://www.realclearpolitics.com/articles/2006/12/obama_can_help_hillary_put_the.html