STRATFOR ON THE ECONOMY & THE ELECTION

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
November 4, 2003

IN THIS ISSUE:

1. Economy Soars Ahead In The 3Q, Report Shows.

2. Stratfor Analyzes The Economy & Election Race.

3. Terrorist Threat May Be Greater In Next Six Months.

4. More Money Managers Are Using “Short” Funds.

Introduction

On Thursday of last week, the government released its first estimate of 3Q economic growth. Gross domestic product, the Commerce Department estimates, surged by a whopping 7.2% (annual rate) in the 3Q, the largest quarterly gain in 20 years. That followed growth of 3.3% in the 2Q and 1.4% in the 1Q. This comes as no big surprise to readers of this E-Letter. Surveys of economists and my best sources have been predicting for months that this economy is in a strong recovery.

From a political standpoint, the latest economic news is a blow for the Democrats. For months they have blasted President Bush over the economy, but the latest data should quiet these criticisms for the most part. In the weeks ahead, look for the Democrats to increase their criticism of Bush’s handling of post-war Iraq and other foreign policy issues.

If history is any guide, Bush should easily be re-elected in 2004, given that we are still at war. At this point, odds-makers would say it’s Bush’s election to lose. This week, I am reprinting some analysis from Stratfor.com, the widely respected global intelligence firm, regarding the economy and the political landscape as we move closer to the election year. I think you’ll find it interesting.

Stratfor On The Economy & Next Year’s Election

QUOTE:

“Continuing to confound conventional wisdom, 2003 is turning into a great economic year while U.S. President George W. Bush's foreign policy is foundering. The decision on Oct. 28 by the U.S. Federal Reserve Bank not to raise interest rates sent the stock markets soaring. Of greater interest was a statement by Bank of Canada Gov. David Dodge that U.S. Federal Reserve Chairman Alan Greenspan told him Washington would announce on Oct. 30 that the U.S. economy had grown at a sizzling 6 percent rate during the third quarter. Greenspan also reportedly predicted that the growth rate would slow down to a mere 4 percent in the fourth quarter -- but he has been consistently conservative in his forecasts.

The roaring comeback of the economy does not surprise us, if we may be permitted to gloat. We have consistently forecasted that the U.S. economy would come back in 2003 much more strongly than most observers predicted. In our view, the recession was a mild, natural and necessary process that set the stage for the next phase of intense growth. In other words, the basic forces that were in place throughout the 1990s -- which are demographic and structural in nature -- have not been eroded by the excesses of the dot-com boom. This is a generational expansion that began in the early 1980s and likely will last well into the first decade of the 21st century.

We regard the concerns about the U.S. deficit as being misplaced as well. The absolute numbers are meaningless. The only relevant measure is percent of deficit relative to gross domestic product. In 1983, when the United States was coming out of a recession, the deficit was 6 percent of GDP. When the United States came out of the recession in 1992, the deficit was 4.7 percent. As of Sept. 30, the U.S. deficit was running at about 3.5 percent of GDP. The deficit at the end of a recession is always at the top of the cycle, since tax revenues are at the low end of the cycle. So the current deficit is acceptable, even without taking into account that there is a war on.

In our view, presidents and senators have very little to do with the economic cycle. Most of their actions come so late as to be irrelevant or are so small as to not have any meaningful impact. One of the strange rituals in the United States is attributing to presidents powers over the economy they don't have, and by the same token holding them responsible for things beyond their control. Former President Bill Clinton did nothing to create the boom of the 1990s, nor was he responsible for the economic crisis into which Bush was inaugurated. Bush was not responsible for the recession, nor did he have much to do with the recovery.

Nevertheless, one of Bush's major worries coming into the re-election campaign is the economy; and one of the great hopes of the Democrats is that a weak economy would propel them into office. That isn't the way the game is playing out. A growth rate of 6 percent -- or even 4 percent -- is not the stuff that Democrats are going to be able to exploit. They will have about six months in which perceptions will lag behind reality. That gives them until spring to continue with the failing economy mantra. It might get them through the primaries, but not the general elections.

That means that, as of this moment, the election is going to be upside down. The Republicans will own the economic story and the Democrats will own the foreign policy issue. It wasn't supposed to be that way, and it might not turn out as such. The problem the Democrats face is this: The economic course is now set. The recession is over and the economy is growing. It might even be beginning another boom. Democrats will have lost that issue by the election in 2004. The issue they will have is Iraq, which is certainly working against the Republicans. The American economy is pretty much set in stone; Iraq isn't. There is a lot of fighting to come during the course of the next year, and it is far from clear that the United States will be the loser. By October 2004, there could be a number of credible scenarios under which the United States has gained control of Iraq.

There are also plenty of scenarios under which Washington won't. That means that this will be an election that pivots on war. Normally in American history, the sitting president wins on issues of war and peace, all other things being equal. The one exception was Lyndon Johnson, who chose to withdraw rather than face the challenge. What history tells us is that unless Bush screws up Iraq as badly as Johnson screwed up Vietnam by 1968, Bush should win. If he gets Iraq under control, he should win by a landslide, adding the economy into the mix.

As Defense Secretary Donald Rumsfeld said, the enemy gets a vote. In this case, they really do. Al Qaeda and the Iraqi guerrillas are well aware of the upcoming U.S. elections and want very much to be seen as driving Bush out of office to build their credibility in the Islamic world. That means they will do everything they can not to be put out of action before November 2004. In fact, they will do everything they can to humiliate Bush before the election. As the economy grows, the war and the election will start to merge. Still, at this moment, the election is Bush's to lose. Given what we have seen in the past few months, however, he seems interested in making it a horse race.” END QUOTE

Check out Stratfor at their website, www.stratfor.com. They have a free section that includes some good information. Their “basic” service is $99 a year, and their “premium” service is $449 a year. I highly recommend Stratfor. (Note: I am not associated with Stratfor and receive nothing for recommending them.)

The Threat Of More Terrorist Attacks

In Stratfor’s last paragraph above, they note that the terrorists desperately want to see Bush voted out of office. He is, after all, the Commander-In-Chief of the War On Terror. They do not want to see him re-elected.

[I find it interesting that, according to Stratfor (and others), the terrorists we are fighting against would welcome a Democrat to replace Bush, thinking that life would be easier for them. Look at the positions of the Democratic front runners: almost all have said invading Iraq was a mistake, even though this contradicts earlier comments and positions and even votes in Congress. No wonder why the terrorists would rather see a Democrat in the White House.]

Stratfor has written more extensively on the continued threat of another major terrorist attack in the US in recent weeks. Stratfor stresses that they have no specific intelligence on any particular terrorist plot, or any particular location. However, they very much believe that the next six months or so, as we move toward the elections, will be the most likely time for another major attack in the United States.

As you know, my outlook for the US economy has been very positive for the last year, and that has proven to be the correct forecast. I have also been positive on the stock markets this year, and that has also proven correct. With the latest scorching economic news (GDP up 7.2% in 3Q), the economy would appear to be on a sound growth path for the next year, and stocks will likely continue at least mildly higher as well.

Yet all that could change if there is another serious terrorist attack in the US. Like Stratfor, none of my other sources have any specific intelligence regarding another attack. Yet if the terrorists are intent on driving Bush out of office, they probably need to strike in the next six months or so.

On the bright side, there has not been a serious terrorist attack on US soil since 9/11. Clearly, the increased security measures we have adopted since 9/11 have lessened the likelihood of another major attack, but they have not eliminated the threat.

As investors, we should not pull all or most of our money out of the markets just because another terrorist attack “might” happen. On the other hand, we should also be ever mindful that another serious terrorist attack in the US could have major negative implications on the economy and the equity markets, just as it did after 9/11.

Another Reason To Use Professional Managers

Most investors I talked to immediately after 9/11 had no idea what they should do, even though the stock markets were closed for several days after the attacks, and they had some time to think about it. Investors didn’t know whether they should bail out when the markets reopened, or just ride out the decline that followed.

Before going any further, let me state the obvious: there is no assurance that a professional money manager will be out of the market and in the safety of cash if another serious terrorist attack occurs. No one saw 9/11 coming.

It is, however, worth pointing out that the equity mutual fund managers we recommend were largely out of the stock market and in the safety of cash on September 11, 2001. Some were 100% in cash; others were 75% or more in cash; and one was 50% in cash when the 9/11 attacks occurred.

There was a reason for this; it was not a chance occurrence. The stock market was in a downtrend in the summer of 2001. These professional Advisors were simply following their systems which try to avoid the downtrends. So, their systems had moved them either fully or partly (at least 50%) to cash ahead of 9/11. As a result, their clients avoided all or part of the carnage in the stock markets just after 9/11. (Past performance is not necessarily indicative of future results.)

I should also point out that, were a serious terrorist attack to happen today, the outcome would be worse. Today, most of our equity managers are fully invested, or near fully invested, in mutual funds (and we’re having a great year). So, if the stock market were to be in an uptrend when a serious terrorist attack occurred, our recommended Advisors might not do any better than individual investors. Still, I would rather have these professionals directing my investments in a potentially chaotic market.

More Managers Using “Short” Funds To Control Risk

Actually, an increasing number of professional money managers are now using “short funds” to hedge their downside risk. How does this work? In recent years, we have seen the development of new mutual funds that actually go up when the stock market falls. The Rydex fund family has its “URSA” (Latin for bear) fund that rises apprx. the same amount as the S&P 500 falls. If the S&P drops 10%, Ursa goes up apprx. 10%. The ProFunds family has its “Bear Fund” which also goes up if the stock market goes down.

Over the last few years, we’ve seen a growing number of professional money managers who invest in mutual funds start to use these “short” funds as a hedge in their portfolios. Rather than sell out of the various mutual funds they own, they simply purchase Ursa or one of the other “short” funds to partly or fully “hedge” their long positions.

Several of our recommended money managers have begun to use these short funds in recent years. If their systems indicate that a downtrend is coming, they can purchase short funds to soften or counterbalance the losses that will occur in their long funds.

I should point out that the use of short funds does not mean that losses will not occur from time to time. No system is perfect and timing the use of short funds is not a perfect science.

With that said, I believe the growing use of these short funds is a good thing, especially for professional managers with long-standing, successful track records such as those we recommend. The availability of the short funds merely gives them one more way to attempt to control downside risk during market downtrends.

The availability of short funds may also prove to be key if regulators place new restrictions on mutual fund trading frequency as a result of the recent short-term trading scandal. If money managers cannot trade as frequently, but see a downturn coming, they can simply buy short funds to hedge their long positions. I will write more about this in the near future.

If you would like to see the actual performance results of our most recommended Advisors, CLICK HERE. If you like what you see, you can call us at 800-348-3601 for more information.

You can also e-mail us. We get dozens of e-mails each week from readers. We answer all of the e-mails we get which ask for a response. It may take us a week or two to respond when we get a heavy load of e-mails, but we will get back to you if you have requested a response. We appreciate your comments (most of them) and suggestions.

Best regards,

Gary D. Halbert

SPECIAL ARTICLES

The long, hard slog – where we stand in the War On Terror.

Don’t read this if you are a Democrat and dislike George W. Bush.

“Metrosexuals?” You never heard this before? Me either.