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On The Economy, Stocks, Tax Cuts & More

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
February 6, 2007

IN THIS ISSUE:

1.  The Economy Surprises On The Upside

2.  Not A Surprise To My Readers. . .

3.  Fed Leaves Interest Rates Unchanged Again

4.  What Is Driving The US Stock Markets Higher?

5.  Supply-Side Economics & Tax Cuts At Work

6.  An Interesting Observation & Question

7.  Conclusions – Enjoy It While It Lasts

The Economy Surprises On The Upside

The Commerce Department, which gauges the ebb and flow of the US economy, released its first estimate of 4Q GDP last Wednesday.  The “advance” GDP report showed that the economy surged ahead by 3.5% in the 4Q of last year, well above most analysts’ pre-report estimates.  This compares to the 3Q when GDP rose only a tepid 2.0% and the 2Q rate of just 2.6%. 

For all of 2006, the economy expanded at the annual rate of 3.4% according to the latest Commerce Department report.  Not too shabby, especially when you compare that to what the gloom-and-doom crowd and many Democrats wanted us to believe last year.  But what else is new?  The economy is being driven by the strong jobs market, despite the slight uptick in the unemployment rate for January to 4.6% from 4.5% the previous month. 

There were several encouraging economic reports released in January.  The Index of Leading Economic Indicators rose 0.3% again in December (latest data available).  The ISM manufacturing index rose from 49.5 in November to 51.4 in December.  Durable goods orders rose 3.1% in December following a gain of 2.2% in November.  Industrial production rose 0.4% in December following a decline of 0.1% in November.  Things are definitely looking up in the manufacturing sector.

The rebound in the economy was led by – surprise, surprise – a surge in consumer spending in the 4Q.  Despite the reports we’ve heard about the disappointing holiday shopping season, it turns out that retail sales actually rose by a solid 0.9% in December versus November, and that does not include the growing “gift card effect” as I will discuss below.  For all of 2006, retail sales rose by 6.0% over 2005 levels, according to the Commerce Department.

The fact that consumers sparked another jump in the economy should not come as a surprise to unbiased observers.  The Consumer Confidence Index rose again in January by 0.3%, following a large increase in December.  The University of Michigan’s Consumer Sentiment Index also surged from 91.7 in December to 96.9 in January.  Consumer confidence has risen significantly from its low point in August of last year. 

As for the so-called ‘gift card effect,’ this refers to the increasingly popular trend of giving pre-paid gift cards from various retailers and malls during the holiday season.  According to the National Retail Federation, gift card purchases in 2006 hit a new record of $27.8 billion, well above the projected target of almost $25 billion, and well ahead of the $18 billion spent on gift cards in 2005.

Interestingly, retailers are not allowed to record the sale when a gift card is purchased; rather, the sale is recorded when the recipient redeems the card to make the actual purchase of goods or services.  Thus, the record large gift card sales during the holiday season may actually serve to boost the economy in the 1Q of this year as people actually spend them, even though the cards were purchased last year.

On the housing front, the latest news was mixed, but on the whole positive.  While sales of existing homes fell slightly in December, new home sales actually increased in December.  Housing starts also rebounded in December, as did applications for new building permits.  The housing sector is not out of the woods by any means, but the latest reports suggest the industry is at least stabilizing on a national basis.

Not A Surprise To My Readers. . .
So Much For The Gloom-And-Doomers

The stronger than expected GDP report last week came as a big surprise to the gloom-and-doom crowd that had promised we were headed into a recession or worse in 2007.  As you might expect, the perma-bears heard the news of the stronger than expected economy and immediately began to warn that the Fed would surely hike interest rates as a result.  They didn’t!  As I will discuss below, the Fed voted unanimously last Wednesday to keep short-term rates unchanged at 5.25% for the fifth consecutive time.

Over the last year, I have consistently advised you that the economy was going to experience a nominal slowdown for 2-3 quarters, with a rebound to unfold in 2007.  I have consistently advised that a recession was not the most likely scenario.  Based on the 4Q GDP report, it looks like the recovery is taking hold even earlier than I thought, although it would not surprise me to see something a little less than 3.5% growth in the 1Q of this year.

Over the last year, I have also predicted that the US equity markets would continue to trend higher, and they have.  The Dow Jones continues to make new record high after new record high.  The broader S&P 500 Index has yet to make a new record high, but it continues to move higher, delivering a total return (including dividends) of 15.79% for 2006. 

I hope you dismissed the gloom-and-doom crowd and took advantage of my advice over the last year!  That is not to say that the gloom-and-doom crowd won’t have their day at some point.  They will.  The only question is when.  In the meantime, the US economy has surprised on the upside for the last 20+ years, and I don’t think the run is over just yet.

Fed Leaves Interest Rates Unchanged Again

The Fed Open Market Committee met last week, and for the fifth consecutive time, elected to leave the Fed Funds rate at 5.25%, which was widely expected.  Prior to the latest stronger than expected GDP report, many analysts (including me) had been predicting that the Fed would be able to lower short-term rates sometime before the middle of this year.  The Bank Credit Analyst has predicted that the Fed would very likely be able to lower rates more than once this year.

Well, that line of thinking pretty much went out the window with the strong GDP report last Wednesday.  Now the thinking has shifted and many analysts fear that the Fed will feel compelled to raise rates in the months ahead.  Several news services described the Fed’s policy statement released last Wednesday as “hawkish.”  I don’t read it that way.  Take a look:

Recent indicators have suggested somewhat firmer economic growth, and some tentative signs of stabilization have appeared in the housing market. Overall, the economy seems likely to expand at a moderate pace over coming quarters.

Readings on core inflation have improved modestly in recent months, and inflation pressures seem likely to moderate over time. However, the high level of resource utilization has the potential to sustain inflation pressures.

The Committee judges that some inflation risks remain. The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.

This latest policy statement is very consistent with those released following FOMC meetings over the last several months.  In fact, with the exception of one word (“Nonetheless”), the last paragraph of the latest statement is identical to the two prior statements in December and October of last year.  Therefore, I do not consider it to be ‘hawkish’ or a warning that the Fed is about to start hiking short rates.

We have come to expect the Fed to continually warn us about inflation, whether or not it is really a significant threat.  While the US inflation rate is still a little higher than the Fed’s target, the rate of increase in inflation is slowing.  That is good news.  Let’s look at some numbers.

The headline Consumer Price Index was up 0.5% in December, while the “core” rate (minus food and energy) was up only 0.2% in December.  For the year, the headline CPI was up 2.5% according to the Labor Department, while the core rate for all of 2006 was up only 1.4%, which is presumably quite acceptable to the Fed.

Another encouraging piece of inflation data was included in last week’s GDP report, which almost certainly had a positive effect on the Fed.  The GDP price index for gross domestic purchases by consumers (formerly called the GDP Price Deflator) rose only 0.1% in the 4Q versus 2.2% in the 3Q.  I have no doubt that this indicator was a big reason why the Fed left interest rates unchanged again last week for the fifth consecutive time.

While the gloom-and-doomers and the perma-bears are now warning that the Fed will soon begin to raise short-term rates, I will not be surprised if the FOMC leaves rates unchanged for several more months at least.  The editors at BCA seem to agree:

…Overall [economic] growth seems likely to bounce around its trend level near 3% [in 2007].  That would be a perfect outcome for the Fed and would not warrant a policy response in either direction.

… As always, the trend in inflation is critical to the outlook, because that will be the key determinant of monetary policy.  As long as inflation stays contained, then Fed policy will be on hold, and the economic expansion and equity bull market should continue.

The bottom line is, the editors at BCA see a continued expansion in the US economy, at least for this year.  The risk of a recession in 2007 seems even more unlikely now, especially in light of the strong 4Q GDP report.  Inflation indicators are not rising as much now, so this is another reason to believe that the Fed will not feel the need to raise interest rates anytime soon.

And let’s not forget BCA’s final note: "…and the economic expansion and equity bull market should continue."

What Is Driving The US Stock Markets Higher?

I talk to investors just about every day.  The Reps at my company talk to even more investors than I do every day.  The most common question we keep hearing from clients and prospective clients is, what is driving the stock markets higher?

It is easy to be a skeptic of the US stock markets.  For many of us, quite honestly, it is always easier to be a skeptic of the investment markets than to be a cheerleader like the always-bullish Wall Street types.  But market skeptics have left a huge amount of money on the table for the last 20+ years, watching and waiting for the market to tank.

Now, here we are in 2007, with the Dow Jones making new high after new high, and yet with all the problems we see, I am still encouraging you to get off the sidelines and get onboard, especially with the professional money managers and strategies I recommend.  Why?   Let me explain, as succinctly as I can.

The world is awash in liquidity, especially in Asia and the oil-producing nations.  I have discussed this in the past.  Unheralded amounts of money are looking for a place to invest.  If you are a foreign investor, is there anywhere safer to invest than in the USA?  NO.  So, you invest in the US, and where better to invest than the US equity markets?

We can talk about all the problems the US is likely to encounter in the next 5-10 years; we can talk about economic and financial crisis scenarios that could develop; we can talk about social/political/moral issues; etc., etc.  We like to talk about these issues, and we should.

But if you are a wealthy Asian, and you need to diversify your investment portfolio, the United States looks very safe and very good.  End of story.  You get some of your money invested in the US equity markets which have a long history of good returns over time.

The point is, the US equity markets are being driven higher in part by the unprecedented demand for investments in the US.  Sophisticated investors around the world are looking to diversify their portfolios, and the US equity markets are increasingly attractive.

What this should point out to us, as investors, is that things have changed.  Old models don’t work the same anymore.  Some of the market equations we learned years ago don’t work so well these days.  Things have changed

To give you one example, when I cut my teeth in the investment markets, “P/E” ratios and similar indicators were the gold standard.  Just not true anymore. P/E ratios have been out of whack (ie – too high) for years, yet the equity indexes just move to new high after new high.  Something else is going on, as I have suggested above.

Supply-Side Economics & Tax Cuts At Work

There is no question that US consumers have driven the robust economy we have enjoyed over the last 20+ years.  A big factor behind the unprecedented consumer demand we’ve seen in recent years is the Bush tax cuts.   Now that the Democrats have taken control of both houses of Congress, and very possibly the White House in 2009, the odds of the Bush tax cuts being rolled back have increased significantly.

With that in mind, one of my staff members reminded me of something I wrote in this E-Letter back in 2003 on the subject of the tax cuts.  It deserves revisiting today.  When President Bush took office, he inherited an economy that was falling fast.  The stock market bubble had already started to burst, and the economy was going into a recession. 

At that time, both the Republicans and Democrats floated proposals to help shore up the economy.  President Bush proposed supply-side economics with tax cuts and business incentives, and the Democrats proposed demand-side (Keynesian) government intervention which, in a nutshell, would have amounted to giving people money to spend to boost the economy.  The Democrats claimed that the tax cuts would do nothing more than reward the “rich” while not having the desired effect of stimulating the economy. 

At the time, I made a prediction as to what I thought would come of the tax cuts.  Here’s what I said in my May 27, 2003 E-Letter:

In my January 7, 2003 (Link) Forecasts & Trends E-Letter, I compared Bush’s proposed tax bill to the one proposed by the Democrats.  In that comparison, I favored the Bush proposal because I believe in supply-side economics.  That’s where money from tax cuts is invested in new businesses and expansion of existing businesses.   This creates jobs, and thus increases consumer spending eventually.

The problem with the supply-side story is that this process takes a while.  Many economists have already gone on record to say that the current tax cut will do little to help the economy by the elections in 2004.  I tend to agree, but I continue to believe the economy is recovering – with or without the tax cut.

What bothers me most about the new tax plan, as noted above, are the sunset provisions.  How much of the tax cut will be invested in long-term business opportunities if those who invest do not know what the tax implications of their investment will be when they cash out or start to receive dividends?  As a financial advisor, I would have a hard time advising a client to make a long-term investment that is primarily based on stable tax policy. 

Of course, the Republicans believe that making the tax cuts permanent is just a matter of time.  I don’t know that I share their enthusiasm.  Just look at the attempts to make the elimination of the estate tax permanent.  The permanent repeal of the estate tax has not passed yet, and may never do so.

As you can see from the above quote, I strongly believed that the Bush tax cuts enacted would lead to a stronger economy in the future.  The problem was that, at the time, we would have to wait for a period of years to see the economic stimulus come to fruition.  Well, we are now witnessing the restorative effects of the tax cuts, which should put to rest any argument to the contrary.  This is especially true in light of what the economy has had to overcome in the last several years – terrorist attacks, huge federal deficits, an expensive war, soaring oil and other commodity prices, etc., etc.

But now the Democrats are now in control.  Will we see them undo all of the good that the Bush tax cuts and other incentives created?  That remains to be seen, but from the talk currently coming from the Democratic leadership, it’s definitely a possibility.  While the Democrats may be savvy enough not to raise taxes overtly, there is a good chance they will simply allow the Bush tax cuts to “sunset” in a few years.  That will be bad news for the economy in my opinion.

The bottom line is, we have a great economy today.  In fact, this is the greatest economic boom in history.  It continues to be driven by consumer spending, which is in no small part due to the tax cuts.  But now we have a Democratically-controlled Congress, and we may well have a Democrat president in 2009.  This raises the odds that the tax cuts will go away – one way or the other – in the next few years.

Admittedly, I have taken what was primarily an economic E-Letter and have now swerved us into a political commentary.  Whenever I write anything political, I get negative comments from some readers who do not share my conservative views.  Yet I have always maintained that political issues can and do affect the markets over the years.

The issue of tax cuts clearly defines why investors should pay attention to politics, as it can and does impact the economy and the investment markets.  This is one reason I will continue to offer political commentaries from time to time, even if they are objectionable to a small subset of my readers.

Politics aside, the economy is rebounding even sooner than expected.  The recession the gloom-and-doomers promised is not playing out.  The equity markets continue to hit new highs, and this looks to continue for a while.  This is precisely why I have consistently urged you to get back in the equity markets for the last several years.  But keep in mind that I have suggested that you do so with a significant portion of your portfolio invested with professional money managers that have time-tested systems with the flexibility to move out of the market (partially or fully) or “hedge” positions should we get into bear market cycles or significant downward corrections.

An Interesting Observation & Question

When you run a company, like I do, and when you are a high-profile writer, like I am, you find that there are questions and issues that your readers won’t ask you.  For example, my crack team of Investor Representatives tell me that one of the most common questions/comments they receive from prospective investors is: The performance of your recommended Advisors on your website seems too good to be true, so is it?

The answer is, it is absolutely true!  All of the performance results on my website are absolutely legitimate and real, and they are always net of all fees and expenses.   Of course, we are required to include the disclaimer that past results are not necessarily indicative of future results.

There are people in the investment business that tout returns which are hypothetical and ridiculous.  My company, Halbert Wealth Management, is a Registered Investment Advisor (“RIA”) with the US Securities & Exchange Commission.   We are registered with other regulatory agencies in various capacities as well.  We are regularly examined by these agencies, and all of our claims are therefore subject to their scrutiny.

When you have a company that is so highly regulated, it is surprising to me that readers would ask if the performance results we publish are really real.  But on the other hand, knowing what you read from the “direct-mail” promoters and other advertisements you get in your mailbox, I can understand why you might be skeptical.

Likewise, the kinds of investment returns that I suggest are reasonable may pale in comparison to what you get in your mailbox or on the Internet.  At the end of the day, I think my readers know what is realistic and what is not.  50% annual returns are not realistic, despite what the direct-mail ads may claim.  Yet the returns achieved by the Advisors I recommend are indeed real, although past results are no guarantee of future results.

CLICK HERE to see the actual performance results for the equity managers I recommend.

Conclusions – Enjoy It While It Lasts

The economy is recovering even quicker than I expected.  The latest report showing GDP rose 3.5% in the 4Q was a very positive surprise.  Too bad for the gloom-and-doom crowd.  The recession they promised is not happening, at least for now.  What else is new?

The always-negative perma-bears have interpreted the latest good economic news to mean that the Fed is about to unleash a new rate hiking cycle based on inflation fears.  I disagree as discussed above.  The Fed could well leave interest rates unchanged for an extended period of time, especially if inflation stays in check, as I expect it will.

The strong US economy will not be derailed easily, but there are growing storm clouds on the horizon.  As discussed above, the Democrats may raise taxes or at least allow the Bush tax cuts to ‘sunset’ in the next few years.  Then there is the huge issue of the Baby Boomers retiring and the enormous strains that will put on our entitlements system.

Hopefully, those problems are a few years away.  In the meantime, we should make the most of the good economy and our investments.  The US stock markets continue to move higher, thanks in large part to the growing wave of global liquidity.  This trend looks to continue in 2007. 

If you are under-invested in US equities, consider the professional money managers I recommend that have the flexibility to move to the safety of cash or hedge positions should market conditions warrant.  And lastly, you have my assurance that the performance returns I quote are indeed accurate results, and they represent the net returns after all fees and expenses have been charged. 

I should know – I have my own money invested in every program I recommend to you.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

How the media describe the economy - depends on who's president.
http://www.aei.org/publications/filter.all,pubID.25556/pub_detail.asp

Inconvenient Global Warming Truths
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John McCain: Born-Again Supply-Sider?
http://www.realclearpolitics.com/articles/2007/02/john_mccain_bornagain_supplysi.html

Hillary Already Being Forced To The Left
http://www.weeklystandard.com/Content/Public/Articles/000/000/013/234ukdvi.asp


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Forecasts & Trends E-Letter is published by Halbert Wealth Management, Inc. Gary D. Halbert is the president and CEO of Halbert Wealth Management, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, Halbert Wealth Management, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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