The Economy, The Markets & What To Do Now

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
May 2, 2006

IN THIS ISSUE:

1. The Economy – Big Rebound In The 1Q

2. Is The Fed Just About Done?

3. BCA’s Latest Forecasts

4. Stocks Hit New Highs In Returns & Risk

5. Third Day Advisors, LLC - Revisited

Introduction

This week, we take a look at the economy in light of the latest Commerce Department report showing that 1Q GDP rose by a solid 4.8% (annual rate), following the tepid rise of only 1.7% in the 4Q. While 1Q GDP was quite strong, there are other indicators that suggest growth will slow somewhat in the next 2-3 quarters.

My view that the economy will soften, at least mildly, in the next several months is consistent with the latest forecasts from The Bank Credit Analyst. I will summarize BCA’s latest May report and their analysis and market recommendations in the pages that follow.

We also consider what the Fed is likely to do in light of the latest economic reports and statements made last week by the new Fed chairman, Ben Bernanke. The minutes from the March 27/28 FOMC meeting suggested that the Fed may end its rate hiking cycle at the upcoming May 10 policy meeting, but with the strong 1Q GDP report, it remains to be seen if the Fed will take a breather.

The stock markets have managed to move to new recent highs as I have suggested over the past year or so, and I expect the equity markets will continue to guardedly progress on the upside. But risks continue to rise, especially if the economy slows down in the next 3-6 months, and certainly if the Fed decides to continue with more interest rate hikes.

Given the increasing risks in the stock markets, I believe it is even more important to have a portion of your equity portfolio managed by professionals that utilize “active management” strategies which have the flexibility to move to cash, or hedge positions if market conditions change for the worse. Given those concerns, I will update you on the performance this year by Third Day Advisors, one of the professional money managers I have recommended in the past in these pages.

Finally, I would like to welcome a very large new group of InvestorsInsight readers this week. If you are reading this Forecasts & Trends E-Letter for the first time, I encourage you to stick with us. In this E-Letter, we cover a broad range of topics including the latest economic outlook, Fed monetary policy, interest rates and inflation, market trends, investments and even politics from time to time. Welcome aboard!

The Economy – Big Rebound In The 1Q

The Commerce Department reported last Friday that Gross Domestic Product jumped 4.8% (annual rate) in the 1Q, following growth of only 1.7% in the 4Q of last year. The 1Q estimate of 4.8% was consistent with pre-report estimates. The jump in the 1Q was primarily attributable to an increase in consumer spending. According to the GDP report, consumer spending jumped 5.5% in the 1Q, versus only 0.9% in the 4Q.

The Consumer Confidence Index jumped strongly from 102.7 in February to 107.2 in March. That puts the Index at the highest level since May 2002. This was much higher than expected, especially in light of the explosion in gasoline prices. With gas prices above $3.00 in many parts of the country, and rising, I expect to see consumer confidence and spending go down at least modestly in the next few months.

In other economic reports, orders for durable goods jumped a surprising 6.1% in March. The unemployment rate dipped back to 4.7% in March from 4.8% a month earlier. New home sales surprised on the upside, up 13.8% in March, after falling 10.9% in February. However, even with the large jump in March, new home sales are still over 11% below the peak last July, and the inventory of new homes for sale is up 24% from a year ago.

The Index of Leading Economic Indicators (LEI) has declined for the last two months in a row. The LEI declined 0.1% in March and 0.5% in February. This is a good indication that the economy will slow down somewhat in the next several months. Most economists have revised their estimates down to 3-3.5% growth in GDP over the next 2-3 quarters.

Is The Fed Just About Done?

As noted above, the minutes from the March 27/28 Fed Open Market Committee (FOMC) suggested that the Fed may raise interest rates one more time at the May 10 policy meeting, and then go on hold. If the Fed raises rates by another quarter point on May 10, that will put the Fed Funds rate at 5%.

Investors and market analysts were encouraged to see the hint in the FOMC minutes that the rate hiking cycle could come to an end after May 10. However, new Fed chairman Ben Bernanke was quick to warn that there are no guarantees.

Speaking before the congressional Joint Economic Committee last week, Bernanke warned: “Of course, a decision to take no action at a particular meeting does not preclude action at subsequent meetings.” This was Bernanke’s way of letting the markets know that the Fed will not hesitate to resume raising rates in the future, especially if inflation should increase.

As for the Fed’s current read on inflation, Bernanke said: “To support continued healthy growth of the economy, vigilance in regard to inflation is essential. The outlook for inflation is reasonably favorable, but carries some risks.” It is still widely believed that the Fed wants to see the “core rate” of inflation (minus food and energy) to be around 2%. For the 12 months ended March, the core rate was 2.1%, down from the previous month.

Bernanke told the committee that the Fed’s forecast is for a moderate slowdown in the economy during the balance of the year. He noted: “The prospects for maintaining economic growth at a solid pace in the period ahead appear good, although growth rates may well vary quarter to quarter as the economy downshifts from the first quarter’s spurt... It seems reasonable to expect economic growth to moderate to a more sustainable pace as the year progresses.”

The bottom line is, it remains to be seen if the Fed will go on hold following the May 10 FOMC meeting. While most everyone agrees that the economy will slow down to a more sustainable pace in the months ahead, it has not yet shown many visible signs of a cooling off, except in the housing sector. Yet, as noted above, I do believe that the latest spike in energy will make a dent in consumer confidence and spending, especially this summer.

BCA’s Latest Forecasts

[Note for our new readers: BCA stands for The Bank Credit Analyst, a research publication which focuses on the economy, interest rates, inflation and market trends. I have been a continuous subscriber to BCA for almost 30 years, and I have found their research to be the most accurate of any publication I have ever read. To learn more, go to www.bcaresearch.com.]

BCA agrees that the US economy is in for a slowdown over the next 2-3 quarters. They do not, however, believe we are headed for a recession, especially if the Fed goes on hold following the May 10 FOMC meeting. BCA’s view is that inflation will moderate slowly once the economy begins to slow down, so the Fed should be able to go on hold after May.

BCA continues to believe that stocks will move higher during the balance of the year, and they continue to recommend above-average holdings of stocks (or mutual funds for most of us). BCA believes that bond yields have over-shot on the upside, and that yields will come down, perhaps significantly, when the economy shows clearer signs of a slowdown. For now, however, they continue to recommend neutral positions in bonds.

Interestingly, in the latest May issue, the editors had some commentary regarding the recent explosion in metals and commodity prices. Given their view that the economy will slow down, and that inflation will peak and turn modestly lower, the editors are not big believers in the current runaway bull markets in metals and several other commodities. In fact, they believe that the huge run-ups in metals and certain commodities have been driven by widespread speculation rather than a huge change in the supply-demand fundamentals. They say: “Commodity prices have overshot on the upside, and are thus vulnerable to a sharp setback.” I agree.

Stocks Hit New Highs In Returns & Risk

Despite soaring oil and gasoline prices, the stock markets have been extremely strong. The Dow Jones is now at the highest level (above 11,000) since early 2000 at the peak of the bull market. The S&P 500 is now above 1,300, the highest level since early 2001. The Nasdaq is also at its highest level since early 2001, but is still far from its meteoric highs set in early 2000.

Several factors are driving stocks higher today. Profit margins and earnings growth for most companies are strong and improving. Valuations are generally reasonable, especially given the current levels in bond yields. Despite repeated interest rate hikes by the Fed, the monetary environment is still accommodative by historical standards. If the Fed goes on hold after May 10, this should be yet another positive development for the equity markets.

Yet while equities have a lot going for them, the risks are clearly increasing. Perhaps the easiest risk to identify is simply the fact that the markets have already risen significantly. The Dow Jones is up almost 50% from its low in early 2003, and the S&P 500 is up over 60% from its low at the same time. Given the magnitude of these gains, it will not take much to spark a significant market correction on the downside.

There are other market risks that are increasing as well. Bond yields have risen significantly so far this year, which is not good for stocks. The strong rallies in precious metals and other commodities send an inflation warning (although these markets seem to be driven more by speculation than an actual increase in inflation). The war in Iraq is not going well. There is talk of a US and/or Israeli attack on Iran.

I could easily see a scenario in which stocks continue to gain ground leading up to and just after the next FOMC meeting on May 10. While it is widely expected that the Fed will go on hold after May 10, there is no guarantee that will happen. In any event, we will not see the minutes from the May FOMC meeting until late June.

By late June, however, it could also be clear that the economy is slowing down. So the news could be dominated by this factor, rather than optimism that the Fed has decided to go on hold. Thus, we could see a significant correction in stocks this summer, if not even sooner. One way or the other, now is a very difficult time for those who are on the sidelines, or are under-invested, in equities. And based on our conversations with prospective clients, a LOT of investors are still on the sidelines.

This is one of the main reasons I recommend that you use professional money managers for a significant portion of your investment portfolio. While no Investment Advisor is perfect, the successful ones have systems that automatically get them into the market when trends emerge, whereas individuals may hesitate and miss strong moves entirely, or get in late and then suffer losses.

Third Day Advisors Revisited

If you are one of our many new readers this week, my company specializes in identifying successful professional money managers through our AdvisorLink® Program. In particular, we are fond of “active management” strategies in which the Advisor can move to the safety of cash (money market) or hedge long positions should market conditions warrant. We also recommend certain Investment Advisors that actually “short” the market from time to time, using some of the inverse mutual funds that make money when the markets fall.

In January 2005, I introduced readers of this E-Letter to THIRD DAY ADVISORS, LLC and its founder, Ken Whitley. I recommended Third Day to more aggressive investors who wanted both a “long” and “short” strategy in their equity portfolio. In early June of last year, I again wrote about Third Day and suggested that it was not too late to get onboard.

Ken Whitley has an impressive performance record using sophisticated strategies that have made money both in bull markets and bear markets in stocks. As I pointed out last year, Third Day: 1) made money in the bear market of 2002; 2) made money in the bull market of 2003; and 3) even made money in the choppy, sideways markets of 2004. I am also happy to report that Third Day continued its winning ways in 2005, easily beating the Nasdaq and the S&P 500 Index for the year. And, Third Day is once again beating those indexes handily so far this year.

Given its impressive performance, and its long and short strategies, I continue to believe that Third Day is an Investment Advisor that sophisticated investors should consider, especially during the uncertain times that lay ahead. Keep in mind, however that Third Day’s money management system, which uses both long and short positions, is an aggressive program. It is therefore not suitable for all investors. Past performance is also not necessarily indicative of future returns.

Performance Evaluation

Many times, strategies that claim to be effective in all types of markets can do well in a bull or bear market, but usually not both. Even the ones that can negotiate both up and down markets often get whipsawed during sideways markets due to volatility and the lack of tradable trends. Thus far, this has not been the case with Third Day.

Since its inception in November of 2001, the Third Day Aggressive Strategy has proven its ability to navigate different market environments by posting an average annualized return of 20.64% as of March 31, 2006, net of all fees and expenses. The worst-ever losing period (or “drawdown”) was –12.18% in the bear market of 2002. See the actual performance history in the tables below for more comparisons and detailed monthly returns.

As you look at the performance numbers below, keep in mind that these are actual results, after all fees and expenses were deducted.

While Third Day’s performance is impressive by itself, it’s even more so when compared to the S&P 500 Index’s average annual return of 6.5% and the Nasdaq 100 Index’s average annual return of 4.5% over the same time period. While past performance is not necessarily indicative of future results, it’s clear that Third Day’s sophisticated model has been effective in dealing with very different market conditions over the past several years.

The minimum investment for the Third Day Aggressive Strategy is $50,000, and the annual fees are 2.5% billed quarterly in advance. Client funds are held in Rydex mutual fund accounts, and investors have access to their accounts through the Rydex website. Account statements are produced quarterly, and Rydex produces year-end tax reports.

If you would like more information on Third Day Advisors, and/or application forms, contact us at 800-348-3601 or visit our website at www.profutures.com.

How Third Day’s Strategies Work

Third Day’s Aggressive Strategy is focused on the Nasdaq 100 Index and, as noted above, will go both long and short depending on its signals. Ken Whitley’s Aggressive Strategy is a proprietary blend of momentum, trend-following and overbought/oversold indicators. There are nine indicators that Ken uses to analyze the market and factor into each trading decision. Each indicator gives a signal on whether to be long, short, or neutral in the market. The model is 100% mechanical (systematic), though Ken does reserve the right to override his system’s signals in the case of a national emergency.

The investment vehicles used in the program are the Rydex Velocity (long) and Rydex Venture (short) mutual funds. [As of Monday, these funds were renamed the Rydex Dynamic OTC and the Inverse Dynamic OTC to be more descriptive.]

Both funds are designed to track the Nasdaq 100 Index. Both funds use leverage and seek to provide investment returns that correlate to 200% of the daily performance of the Nasdaq 100 Index, with Velocity providing a positive correlation and Venture providing a negative correlation. Because of the leverage in these two funds, Third Day Aggressive is never 100% invested.

Unlike most other mutual funds, these Rydex funds allow Third Day to trade in or out of a fund TWO TIMES per day, once at 10:45 AM Eastern time and again at the close of business at 4:00 PM Eastern time. Ken Whitley believes this ability to trade twice a day is a big advantage.

The Third Day Aggressive Strategy does not currently employ any traditional “stop-loss” techniques to automatically exit trades. This is another reason why the program should only be considered by aggressive investors who are comfortable with high volatility and periodic drawdowns.

Please refer to our online Advisor Profile for additional details regarding Ken Whitley’s background, the Third Day Aggressive Strategy, the trading platform, fees and expenses, etc. Be sure to read the important information on Page 4 of the Profile that provides additional disclosures about Ken’s program and it’s historical track record and see IMPORTANT DISCLOSURES at the end of this E-Letter.

Conclusions

The Third Day Aggressive Strategy can be an attractive option for sophisticated investors who understand risk and want to diversify their portfolios by adding a manager that can have both a long and short exposure in the market.

As noted above, the program has an average annualized return of 20.64%, net of all fees and expenses, with a worst-ever drawdown of only –12.18%. Past results are not necessarily indicative of future results.

Yet the most impressive thing about this program is that it has shown outstanding results during the last four-plus years of very different market conditions.

And you can access Third Day for a minimum investment of only $50,000.

Our analysis has also shown that Third Day’s historical returns have little or no correlation to the S&P 500 Index, as well as many of the other Advisors featured in our AdvisorLink® Program. Thus, Third Day may be an ideal complement to buy-and-hold asset allocation strategies, as well as other actively managed investments offered by ProFutures.

Back in January of 2005, I told my readers that the Third Day Aggressive Strategy was one of the most impressive programs I had seen in several years. Since that time, Ken Whitley has done nothing but increase the confidence I have in him as a money manager.

Given the many uncertainties and risks in the stock markets today, adding a manager like Third Day may be a very good idea, especially if you want exposure to both the long and the short side of the market. Third Day has been successful in up markets, down markets and even sideways markets. Keep in mind, however, that past results are not necessarily indicative of future results. Be sure to read the IMPORTANT DISCLOSURES below.

If you want to learn more about the Third Day Aggressive Strategy, or have questions regarding any of the information provided above, you can call ProFutures at 1-800-348-3601, e-mail us at mail@profutures.com, or complete an online request form. We also recommend other professional money managers with less aggressive strategies than Third Day. Call us for more information or check them out at www.profutures.com.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Republicans Running On Empty.
http://www.realclearpolitics.com/articles/2006/05/republicans_running_on_empty.html

Sour news for GOP in poll.
http://www.usatoday.com/printedition/news/20060502/1a_lede02.art.htm

“Blowback” on the press.
http://www.realclearpolitics.com/articles/2006/05/blowback_on_the_press.html

IMPORTANT DISCLOSURES

ProFutures Capital Management Inc. (PCM), Third Day Advisors, LLC, and Purcell Advisory Services, LLC are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. This publication is not intended as personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. PCM receives compensation from the Advisors in exchange for introducing client accounts to the Advisors. For more information on PCM or any other Advisor mentioned, please consult PCM Form ADV II, available at no charge upon request. Officers, employees, and affiliates of PCM may have investments managed by the Advisors discussed herein or others.

As a benchmark for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends) represents an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of the S&P 500 or other benchmarks cited may differ materially (more or less) from that of the Advisors. Historical performance data represents actual accounts in a program named Third Day Aggressive Plan, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC. Purcell Advisory Services utilizes research signals purchased from Third Day Advisors, an unaffiliated investment advisor. The signals are generated by the use of a proprietary model developed by Third Day Advisors. In all cases, performance histories reflect a limited time period and may not reflect results in different economic or market cycles. Statistics for “Worst Drawdown” are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Investment returns and principal will fluctuate so that an investor’s account, when redeemed, may be worth more or less than the original cost. Any investment in a mutual fund carries the risk of loss. Mutual funds carry their own expenses which are outlined in the fund’s prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Individual account results may vary based on each investor's unique situation. No adjustment has been made for income tax liability. Performance for other programs offered may differ materially (more or less) from the program illustrated. Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.