The Bank Credit Analyst’s Forecasts For 2005

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
January 3, 2005

IN THIS ISSUE:

1. My History With The Bank Credit Analyst

2. Not Always Right, But Rarely Ever Wrong

3. BCA’s Economic Forecast For 2005

4. BCA’s Market Forecasts For The Year

5. A Debt Crisis Looms In Our Future

6. A Good Way You Can Help With Disaster Relief

Introduction

This week, I will review the latest forecasts for the economy and the major investment markets for 2005 from The Bank Credit Analyst. BCA is one of the most widely followed and respected research groups in the world. As long-time clients and subscribers know, I have been a continuous subscriber to BCA’s various services for many years, and I have frequently summarized their forecasts in my monthly newsletters and more recently in these weekly E-Letters.

BCA offers a wide range of research services covering the US and global economies, all of the major stock markets around the world, foreign currency trends and periodically, the energy and precious metals markets. To subscribe to all of BCA’s various services, it will cost you well over $10,000 per year. To learn more about BCA, go to www.bcaresearch.com.

BCA predicts that the US economy will continue to grow by 3-3½% in 2005, with no recession likely. Beyond 2005, however, BCA says the outlook is much less clear, and the editors warn that the US will face a debt crisis sometime in the next few years. I also bring you their latest market forecasts for what they call “A Year of Living Dangerously.”

My History With The Bank Credit Analyst

For the benefit of our newer E-Letter subscribers, let me briefly review my history with BCA. In late 1977, one of my clients sent me a copy of BCA and recommended that I subscribe in order to help with my own forecasts for the investment markets. While BCA’s publications are quite expensive relative to most, I subscribed and soon became a loyal follower of their advice.

In late 1977, we were in a runaway inflationary period. At that time, the Dow Jones was around 800 and Treasury bonds were out of favor. (Interestingly, Treasury bond futures began trading at about the same time I first subscribed to BCA in August of 1977).

At that time, BCA was predicting that the inflationary trend in the US was going to accelerate even further. Their advice at the time was to hold below-average investment positions in equities and bonds, but they also recommended that investors accumulate above-average positions in tangible assets such as real estate, precious metals and collectibles. They also predicted that the US dollar would plunge.

I was a “perma-bear” back in those days, meaning that I had a very negative bias toward stocks, so I welcomed BCA’s advice to load up on tangible assets. Gold, for example, was well below $200 per ounce at the time, on its way ultimately to $850; silver was around $5 per ounce, on its way ultimately to over $35. Most of my clients loaded up on precious metals and other inflation-sensitive commodities. Many also shorted the US dollar. From an investment perspective, it was a grand old time. We thought it would never end.

But then something happened. In October 1979, a relatively unknown man, Paul Volcker, was appointed as the new Federal Reserve chairman. Volcker announced that he was going to take bold new steps to stop the runaway inflation in the US. Few people took him seriously at first. I didn’t. Precious metals and tangible assets continued to skyrocket. My clients thought I was a hero.

But in November and December of 1979, BCA issued a stern warning. They very much believed that Paul Volcker was serious, and that he was prepared to raise interest rates, dramatically if necessary, in order to reverse the runaway inflation in the US. They recommended immediately liquidating positions in precious metals and tangible assets. They also predicted that a recession would unfold as a result of the interest rate hikes.

I will tell you that I agonized over what to do. I thought BCA was wrong and that inflation would continue higher. I very much believed that precious metals and tangible assets would continue higher for at least another year. Most of the newsletter writers in the so-called “hard money” world were predicting that gold was going to $2,000 or higher.

Yet by this time, my respect for BCA had grown to a point that I could not ignore their warnings. So in late 1979, I insisted that all of my clients follow BCA’s advice and liquidate all of their precious metals and other inflation-sensitive investments that I had put them in over the two previous years.

Many clients were unhappy with me, even though they had made huge profits. Some clients closed their accounts. A few refused to take my advice, and in those cases, we transferred their accounts to other investment firms. Meanwhile, inflation continued and precious metals prices continued to explode on the upside. But by mid-December 1979, all of my clients were out of the precious metals markets and their US dollar short positions.

As noted above, gold skyrocketed above $800 per ounce in late December, and silver soared above $35 an ounce. More than a few clients reminded me that I had gotten them out too early. I was no longer a hero.

But most of you will remember what happened next. Paul Volcker made good on his promise to ratchet up short-term interest rates. The historic bull market in precious metals peaked at the end of 1979 and an even more historic collapse followed. Gold plunged from above $800 to below $500 by the end of January 1980. In silver, the crash was even worse with prices collapsing from above $35 an ounce to below $12 by the end of March 1980. Many investors were completely wiped out.

But thanks to BCA, my clients and I avoided one of the worst market debacles in history.

As most of you will remember, short-term rates eventually went above 16%, and Treasury bond yields soared to near 14% as Volcker continued his war on inflation. By the end of 1980, we were in the recession that BCA had predicted. The Dow Jones fell from 1,000 to near 700 by the end of 1981. Things were bad in the investment world.

Yet in early 1982, BCA had yet another monumental forecast. While most analysts in the investment world were bearish, BCA predicted that: 1) the recession would end in 1982; 2) the economy would begin a strong recovery; and 3) stocks would begin a powerful, multi-year run on the upside. They also predicted that interest rates would continue to fall. They recommended above-average positions in equities and bonds.

In early 1987, BCA warned subscribers that the equity and bond markets had become overheated on the upside and recommended that investors scale back their holdings of stocks and bonds. As it turned out, the bond market turned sharply lower in mid-1987, and we had the October crash in the stock markets. BCA subscribers who followed their advice side-stepped much of the damage.

Not Always Right, But Rarely Ever Dead Wrong

I could go on with more examples of timely forecasts by BCA. They were generally very accurate in their predictions on the economy and the major investment markets during the 1990s as well. I should point out, however, that BCA does not have a crystal ball. While they are absolutely the best source I have ever found for forecasting major trends in the US and world economies, they do not catch all the major trends in the markets.

In early 2002, for example, BCA advised investors to reduce holdings of Treasury bonds to below-average positions. They believed that Treasury yields would remain high and thus saw little potential for bonds to advance. As it turned out, bond yields peaked in March/April of 2002, rates fell significantly for the rest of the year and into 2003 and bonds appreciated significantly in value.

This is an example illustrates that BCA will miss some market movements from time to time, but they are rarely ever outright wrong in predicting the major direction of the economy and the investment markets. I might add, however, that the bond market collapsed in early mid-2003, and reversed most of the gains made over the prior year.

The point is, BCA is not perfect (no one is) but they have a better record overall than any source I have found in the last 28 years.

BCA’s Outlook For 2005

In late December each year, BCA issues its various forecasts for the New Year, and I will summarize their latest thinking for you below. Like everyone, BCA qualifies its forecasts for 2005 with the caution that if there are more serious terrorist attacks in the US, then everything could change. That’s a given. Before getting into BCA’s forecasts for 2005, let’s briefly look back at their outlook for 2004. In December 2003, BCA predicted that: 1) the global economic recovery would continue; 2) the Fed would raise short-term rates several times; 3) stocks would rise but probably only modestly; 4) the US dollar would continue to fall, but not crash; and 5) commodity prices would remain in an uptrend. Other than missing the nice move in Treasuries last year, their advice was right on.

In their latest “Outlook 2005,” the editors are actually optimistic that the economy will continue to expand all year. As you may know, there are many in the forecasting business who believe that the recovery will stall out this year, and that a recession will unfold later this year. The BCA editors predict that US GDP will average 3-3½% this year. Short of a major negative surprise, BCA does not believe we will see a recession unfold this year.

BCA’s forecast of 3-3½% is slightly less than the latest Wall Street Journal economic survey released on Monday. The WSJ polled 56 leading economists, and the average forecast is for GDP to grow by 3.6% in 2005. They rated the chance of a recession by the end of 2005 at only 11%.

Many analysts argue that consumer spending, which makes up over two-thirds of GDP, will decline in 2005. They point to the new high in consumer debt and very low savings rate in the US. BCA argues, however, that the economy will produce real income growth of apprx. 3% in 2005, and that this will lead to an increase in personal consumption spending by about the same amount (3%) this year.

The editors also see the decline in the US dollar continuing this year. Unlike some forecasters who see the dollar decline turning into a currency crisis, BCA expects the decline to be gradual again this year. Many analysts worry that the dollar decline will make foreign governments unwilling to continue purchasing very large amounts of US debt, as has been the case for the last several years. This, they contend, will lead to a global financial crisis.

BCA very much believes that such a global financial crisis is coming at some point, but they don’t believe we are near that point just yet, barring any major negative surprise (such as another terrorist attack). For 2005, BCA believes foreign governments will continue to buy large amounts of US debt, and that this will keep medium and long-term interest rates relatively low.

“The painless nature of the dollar’s drop indicates that there is plenty of global capital available to finance the U.S. current account deficit. Weak demand in the global economy means that there are excess savings, and these inevitably find their way into U.S. assets. Thus, major problems should not erupt until demand improves in the rest of the world to the point where the pool of excess savings dries up, forcing the U.S. to compete for capital. That could then push up U.S. interest rates and trigger problems in the debt-heavy consumer sector.”

The editors believe that inflation will remain low this year. Nevertheless, they do expect the Fed to continue to raise short rates several more times in 2005.

“The Fed will keep raising rates to at least 4% as long as the economy is growing at a steady pace and inflation is stable or drifting higher. Policy will go on hold if the economy clearly weakens and/or inflation heads lower.”

One of BCA’s concerns is that the Fed will raise short-term rates too high and thus short-circuit the economic recovery. While the Fed would not intentionally do so, it has made such mistakes in the past. Yet BCA believes the odds of that happening in 2005 are low.

BCA On The Investment Markets

With those predictions for the economy and interest rates, what do the editors have to say about the investment markets? It is safe to say that the BCA editors are not enamored with either US stocks or US bonds. They believe US equities will move higher in 2005, but they expect returns to be in the single digits again while volatility could well increase.

The editors caution investors to keep a close eye on the Fed. Their concern is that if the Fed begins to raise rates more aggressively, this could be negative for equity prices in general.

The editors did recommend that investors increase weightings of large cap stocks and reduce holdings of small cap stocks. They argue that large cap stocks will benefit more from the falling dollar, and that small cap stocks will be hurt more by rising short-term interest rates.

They also favor European stocks over US equities. Specifically, they recommend buying high quality stocks of the UK and France on dips in those markets.

As for the US bond markets (Treasuries and high quality corporate bonds), BCA sees a trading range as the most likely scenario in 2005. As noted above, they believe there is plenty of foreign capital available to purchase Treasury debt and thus keep yields relatively low. Yet at the same time, the strong economy and the Fed raising short-term rates create pressure for higher yields. In the end, and barring any major negative surprises, the editors seem to think bonds will be in a trading range for most of this year.

Here, too, the editors favor Euro zone bonds over US bonds, at least for the first half of 2005.

As for the commodities markets, the BCA editors believe that oil prices have now moved to a new and likely permanent price plateau, with a floor of around $40 and ceiling that is unknown. This is consistent with the views of many other analysts in the energy markets.

As for gold and precious metals, the editors believe these markets will continue to benefit from the falling dollar, but they also believe the bull market may be overextended at this point. They feel that gold, for example, could correct down to the $380-$400 area where it would be a good buy again.

Trouble Looms In The Coming Years

While BCA predicts that the economic expansion will continue in 2005, they also warn that some very difficult economic and financial times lie ahead in the not-too-distant future. They warn that whenever the next serious recession occurs, it could lead to a global financial meltdown.

While the editors believe that Asia and other foreign countries will continue to purchase large amounts of Treasury debt for another year or longer, they also believe the day is coming when this excess global liquidity will evaporate. When that happens, the US will face very difficult choices.

The problem is, no one knows when the next serious recession will hit. It could occur in 2006 or 2007, or it could unfold at any time if there are more serious terrorist attacks in the US. We just don’t know. This explains why BCA subtitled its Outlook 2005 as “A Year of Living Dangerously.”

Conclusions

In the space of a week or so, we have BCA predicting 3-3.5% GDP growth in 2005, and no recession, plus the Wall Street Journal economic survey with a consensus 3.6% increase in GDP this year. That’s the good news.

BCA predicts that stocks will trend higher but probably at only single-digit returns with continued high volatility. If this forecast proves to be true, that means most “buy-and-hold” stock market investors will be taking a LOT of risk to make disappointing returns.

The bond market could remain in a broad trading range for much of the year, worrying along the way about the Fed raising short-term rates and the falling US dollar. Here, too, buy-and-hold bond investors will be taking a LOT of risk for what could be low returns or no returns.

BCA believes investors might see better returns by investing in European stocks and bonds, but let’s face it – most Americans aren’t going to buy European stocks or bonds (especially not France).

Other than the economy, BCA’s latest forecasts are disappointing for most investors, especially those who use only buy-and-hold strategies or are accustomed to investing in “index funds” which only do what the markets do.

At the risk of sounding like a broken record, these forecasts speak to the need to have professional managers with time-tested systems that can move into or out of the market periodically as market conditions warrant. The successful managers that use these strategies have the potential to increase returns while at the same time reducing risk.

If you have not looked at the professional managers I recommend, you should check them out this month and see if they are suitable for you. Or feel free to give us a call at 800-348-3601 and speak to one of our Investor Representatives.

How YOU Can Help With The Tsunami Disaster

If you’re like me, you want to donate to the Tsunami disaster relief effort, but you are not sure where to donate to get the most bang for your buck – in terms of real help, that is. Knightsbridge International ( www.kbi.org) is a US-based non-profit organization that I believe deserves your attention.

Knightsbridge is an all-volunteer NGO (non-governmental organization) that has brought aid to some of the most dangerous and roughest spots in the world. These are some really good men (if not a little crazy based some of the life-threatening situations that they have endured). They have been featured on National Geographic and in papers worldwide. When you donate to them, 100% of your money goes to the field. There are no salaries, overhead expenses or fund-raising costs.

Sir Ed Artis of Knightsbridge is heading up a massive relief effort to Sri Lanka. Knightsbridge has a special source for medicine and relief supplies. For around $150,000 they can get over $5 million worth of medicine and supplies, enough to fill a 747 that is also made available to them by a wealthy supporter. Artis will be personally flying on the jumbo-jet to Sri Lanka along with Dr. James Laws of Knightsbridge and other volunteers, to personally see that the supplies get to where they are needed most. And they hope to do more 747 shipments soon. But they can only do this if more donations come in.

These guys are real present day heroes who risk their lives and their net worths to bring aid to dangerous parts of the world. I suggest you check them out and consider making a donation. I am donating personally as well. Again, the website is www.kbi.org.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

We are the world – only the US can do the disaster heavy lifting.
http://www.opinionjournal.com/columnists/bminiter/?id=110006107

On tsunami’s shore – US jumps in with both feet while the UN only criticizes.
http://www.washingtontimes.com/functions/print.php?StoryID=20050103-085311-2613r

Where will the economy go in 2005?
http://www.weeklystandard.com/Content/Public/Articles/000/000/005/092kdqle.asp