What’s Going On With The Economy & The Markets?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
June 6, 2006

IN THIS ISSUE:

1. The Economy – Are We Headed For A Recession?

2. Fed Hints More Rate Hikes To Come

3. Fed Chairman Bernanke Taking Some Lumps

4. The Bank Credit Analyst’s Latest Forecasts

5. Asset Classes Are Becoming More Correlated

6. What This Means For Investing Going Forward

7. Bottom Line: The Need For “Risk-Adjusted” Returns

Introduction

Summer’s here, school is out, time for some fun, take a vacation, enjoy – right? Except that the stock markets are in the tank, the high-flying metals and commodities markets are plunging, and virtually everyone now believes the Fed is going to continue to ratchet up interest rates at least a couple more times. So, we’re not heading into summer on the most positive of notes. In fact, most investors are scratching their heads.

On the other hand, if you have been reading this E-Letter closely recently, you are not the least bit surprised with the recent turn of events. On May 9, I wrote: “The stock markets have risen to new highs of late, largely on the assumption the Fed will go on hold after tomorrow. This assumption has also helped to accelerate the runaway bull markets in precious metals and certain other commodities. Yet if the Fed fails to give the good news the markets are looking for tomorrow, we could see some nasty setbacks. Specifically, if the Fed doesn’t hint that it is going on hold for a while, that will very likely be bad news for the equity markets, metals, etc.”

As you no doubt know by now, the Fed did not hint on May 10 that it is going on hold, but rather suggested that it would make upcoming interest rate decisions based on the latest economic information available. That was a big disappointment but, again, no surprise to my clients and readers. On May 23, I wrote: “The bottom line is, if it becomes clear the Fed is going to raise rates another 2-3 times, this will not be good news for the stock markets or the previously high-flying commodities markets. As we have seen over the last few weeks, these markets can fall hard and fast!”

So, here we are in the first week of June when we should be in a festive mood, yet most investors and market analysts are in a funk. The perception is that the Fed will indeed hike interest rates at least a couple more times. The minutes from the May 10 FOMC meeting were released last Wednesday (May 31), and some analysts are even fearing that the Fed will raise rates by 50 basis points (instead of just 25) at the next FOMC meeting at the end of June. There is a growing feeling that the Fed could send the economy into a recession by the end of this year.

Even some of my colleagues I respect are wondering if we are witnessing the beginning of another 1987-style stock market crash. The gloom-and-doom crowd is carping that we’re headed for a new depression. But what else is new - for them, the sky is always falling!

So, this week we will look at the latest economic numbers, the latest inflation numbers, the latest hints from the Fed, the latest analysis from The Bank Credit Analyst and the latest market developments to see if we can make any sense of where we’re headed. Let’s get started.

The Economy – Are We Headed For A Recession?

Virtually everyone in the forecasting business believes that the US economy will cool off somewhat in the second half of the year. Most estimates are that GDP growth will slow to around 3%. However, the Commerce Department revised its advance estimate of 1Q GDP from 4.8% to 5.3% (annual rate). This rise in GDP, along with higher than expected inflation in April (+0.6%), and the implications for more Fed rate hikes, sent the stock markets reeling lower along with the metals and other commodities.

The economic reports for April suggest the economy is slowing at least somewhat from the blistering 5.3% 1Q. The Index of Leading Economic Indicators was down 0.1% in April, versus up 0.1% in March. Durable goods fell 4.8% in April, while retail sales rose modestly (up 0.5%). The ISM manufacturing index fell in April from 57.3 to 54.4.

On the housing front, the news for April was mixed. New home sales rose 4.9% while existing home sales fell 2.0%. The average home price was $222,700 in April, which is 4.3% above yearago levels, but well below the peak. The worst news was that the inventory of homes on the market in April was up 40.5% over yearago levels. The housing markets should continue to soften in the second half of the year.

Consumer confidence fell sharply in May. The Conference Board’s Consumer Confidence Index fell 6.6% in May after hitting a four-year high in April. The University of Michigan’s Consumer Sentiment Index plunged from 87.4 in April to 79.1 in May. Survey participants cited soaring gasoline prices as the main reason for their loss of confidence.

The unemployment rate in May fell from 4.7% to 4.6%; however, the 75,000 new jobs reported in May was less than half the pre-report consensus.

While the reports noted above, and others, are somewhat mixed, it does appear that GDP growth in the 2Q will be lower than that of the 1Q. With the latest plunge in consumer confidence, 2Q growth is likely to be significantly lower than the 5.3% pace in the 1Q. But that does not mean we are headed for a recession. We will discuss this more as we go along.

Fed Hints More Rate Hikes To Come

As noted above, the Fed did not send the message the markets were hoping for on May 10. Rather than hinting that the FOMC would go “on hold” after the May 10 increase, the announcement suggested that more rate hikes likely lie ahead. There is no question in my mind that the fear of more rate hikes was the main reason why the markets sold off as they did in the last half of May. That is why I issued the caution noted above in my May 9 E-Letter.

The minutes of the May 10 FOMC meeting were released to the public last Wednesday, and they are not encouraging to those who think the Fed should stop the rate hikes. The minutes indicated that certain FOMC members argued for a 50 basis point increase in May or June, while others argued for no further rate hikes after May. While it is no surprise, the May FOMC minutes make it clear that the FOMC is very concerned about the recent rise in inflation.

New Fed chairman Ben Bernanke had some additional hawkish comments on inflation as he spoke to the American Bankers Association yesterday in Washington, and his remarks sent the equity markets reeling lower once again. Bernanke said the Fed “will be vigilant to ensure that the recent pattern of elevated monthly core inflation readings is not sustained.”

He went on to say: “While monthly inflation data are volatile, core inflation measured over the past three to six months has reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth.”

While Bernanke hinted in late April that the Fed might be just about done raising interest rates, he has certainly erased that line of thinking with his latest comments and those discussed just below. The question is, could the Fed chairman be over-reacting to the April inflation report?

The interest rate futures markets are now priced for another quarter-point increase in late June. In fact, futures traders’ odds for a rate hike in late June surged from just 58% on the Tuesday before the FOMC minutes were released to 78% odds the day after the minutes came out.

My bet is that the FOMC members will key off of the Consumer Price Index for May. Obviously, the CPI for April was a disappointment to the Fed, with the core rate at 2.3%. The CPI figures for May will be released on June 14, two weeks before the next FOMC meeting on June 28/29.

My thinking is that if the May inflation numbers show the core rate down somewhat from the April rate of 2.3%, the Fed will raise rates in late June and, most importantly, hint that they may go on hold and not raise rates again at the August meeting. But if the May inflation numbers are again on the high side, I would expect rate hikes in June and August. In the meantime, expect the markets to remain quite volatile.

Fed Chairman Bernanke Taking Some Lumps

New Fed chairman Ben Bernanke is still learning the ropes at the Fed. In my May 2 E-Letter, I discussed some of Bernanke’s recent comments and congressional testimony that many analysts took as a hint that the Fed was just about done hiking rates. Yet in my May 9 E-Letter, I included the following:

“According to CNBC’s Maria Bartiromo, she spoke with Bernanke at the recent White House Correspondents dinner. She reported that Bernanke told her that, even if the Fed goes on hold at the June 28/29 FOMC meeting, it would almost certainly resume raising rates at the following policy meeting on August 8.”

Interestingly, Bernanke was “called on the carpet” for his remarks to Bartiromo by the Senate Banking Committee last week. Bernanke reportedly apologized for the misstep and promised to limit his public comments to the “normal channels.” Bernanke also announced he has appointed a panel to examine better ways to communicate policy. The panel will be led by Fed governor Donald Kohn, who was recently appointed vice chairman of the Federal Reserve’s board of governors.

BCA’s Latest Analysis & Forecasts

The editors at The Bank Credit Analyst continue to believe that the US economy will slow down to a growth rate in the 3% area over the next 2-3 quarters. BCA predicts that consumer spending will slow markedly in the second half of the year. The combination of the negative savings rate, the softening of the housing market and continued high energy prices will take a toll on consumer spending, and this will slow the economy to a level at which the Fed can end the rate hiking cycle. BCA believes the odds are very good that the rate hike in late June will be the last one.

BCA also continues to believe that inflation will fall in the second half of the year. The editors point out that core inflation is now below 2% in almost all of the other industrialized nations, and that it is only a matter of time before the core rate in the US (2.3% in April) will fall to 2% or below. This is why they believe the rate hike in June could be the last for this cycle.

BCA expects interest rates to turn lower as the economy slows down and the Fed winds down its rate hiking cycle. However, the editors did not go so far as to recommend adding to positions in bonds. For stocks and equity mutual funds, the editors view the latest sell-off as a buying opportunity, especially for those who are underweighted in equities. The editors caution that the stock markets will continue to be volatile until there is confidence that the Fed is done with rate hikes, but they are of a buy the dips mentality:

“We do not expect the economic and financial environment to turn hostile enough to justify a major drop in equity prices. As we have discussed, interest rates have probably peaked, and the economy faces a mid-cycle slowdown rather than a recession.”

As for the recent sharp declines in many commodity prices, the editors at BCA believe these markets could still fall even further. In particular, they believe that most of the metals markets are still overpriced, based on the fundamentals, and thus more weakness could lie ahead in the short-to-medium term. Long-term, the editors still believe that industrial commodities are in a bull market, but prices got way too high largely due to frothy speculation.

The editors believe the US dollar has resumed its long-term downtrend. They believe that if the economy slows, interest rates trend lower and if the Fed ends its rate hiking cycle, the dollar will move to new lows, although they caution that the currency markets will likely remain quite volatile in the near-term.

Editor’s Note: I have been a continuous subscriber to The Bank Credit Analyst for the last 29 years, and I have found their economic and financial advice to be the most accurate of any other service I have followed. As such, I highly recommend BCA. To learn more about their services or subscribe, go to www.bcaresearch.com.

Asset Classes Are Becoming More Correlated

The recent sell-off in the stock markets didn’t surprise most market analysts, given that the Fed did not send the message most participants were looking for – that the Fed might go on hold for a while. However, what did surprise many investors and market analysts was the fact that the metals markets and numerous other commodity markets sold off hard as well.

But the sell-off in the metals markets and other commodities did not come as a surprise to readers of this E-Letter, as noted in the Introduction above. Rather than reacting to the higher than expected inflation in April, the metals and commodities markets reacted to the likely implications of more rate hikes from the Fed, as I suggested on May 9 and again on May 23 before the minutes of the May 10 FOMC meeting were released.

The point to be made here is that the various investment markets are becoming more correlated. The various asset class prices are tending to move more in tandem than independently, as they have in the past. This is important.

For decades, investment professionals have preached the importance of diversifying among different asset classes, and especially among asset classes that have low or negative correlation in terms of gains and losses. Such asset classes have previously included: US stocks (large caps, small caps, etc.), international stocks, emerging market stocks, bonds, real estate, precious metals and other commodities, etc.

Stocks and bonds, for example, have had a fairly low level of positive correlation historically, and this is why most asset allocation models include a healthy dose of stocks and bonds. There are also certain asset classes that have negative correlation, meaning that when one goes down, the other goes up and vice versa, generally speaking. For example, it has long been believed that when stocks go up, commodities tend to go down, and vice versa. And generally speaking, that has been true historically.

You diversify among multiple asset classes, with low or negative correlation, in the hopes of smoothing out overall returns, while at the same time reducing net losses along the way.

Yet over the last few weeks, we have seen stocks around the globe AND commodities go down at the same time, and at a time when housing and real estate prices have been softening in many parts of the world. So what is happening? Let me first give you a few numbers, and then I will give you my thoughts on why this phenomenon is happening.

A recent research report from Merrill Lynch found that as of February of this year, small cap stocks were 94% correlated with the large cap stocks that make up the S&P 500 Index, which means that in a year when the S&P 500 Index rose, an index of small stocks also rose 94% of the time on average. Just a few years ago, the correlation between the S&P 500 Index and small stocks was only 62%.

Here’s a more dramatic example. Six years ago, emerging market stocks (as measured by the MSCI EAFE Index) had only a 32% correlation with the S&P 500 Index. According to the recent Merrill Lynch study, that correlation had vaulted to 96%! Emerging stocks are now trending in line with the US S&P 500 Index.

Even commodity prices are starting to mimic the equity markets. Imagine commodities like oil and precious metals increasingly moving in tandem with stocks. For purposes of example, I will cite the Goldman Sachs Commodity Index (GSCI) which tracks the prices of 24 traditional commodities markets (energy, metals, grains, food, lumber, etc.). As recent as 2000, the GSCI had a negativecorrelation of 14% with the S&P 500 Index, meaning that commodities tended to move up when stocks moved down and vice versa. According to the Merrill Lynch study released in March, commodities have recently shown a positivecorrelation of 33% with the stock markets. So even commodities are recently trending with equities.

In response to this study, the Wall Street Journal (WSJ) asked the following: “For investors, that [Merrill Lynch study] poses a troubling issue: how to maintain a portfolio diversified enough so that all the pieces don’t tank at once.” Good question! I’ll give you the answer below.

Why Is This Happening? Answer: Globalization

We can talk about this all day long, but the answers are actually quite simple. We live in a global economy. We live in an era of global communication. Can you say, COMPUTERS and the INTERNET? We also live in an age of global investing. Investors can move their money virtually anywhere, anytime. And they do.

Markets are becoming more homogenous. Money can move daily or in many cases, hourly, around the globe, to whatever sector is perceived to be the new hot spot. This will only increase in the future as global communications accelerate. Get used to it.

What This Means For Investing Going Forward

I don’t have all the answers, but I do have some advice. For one, the globalization of investing is no doubt going to increase. More and more people are going to learn to move their money around at increasing frequency and into more and more market sectors and opportunities – US and elsewhere. Maybe you won’t but your kids will. Count on it!

Second, the risk is, more and more people will be chasing the latest “hot” returns and the latest “hot” sectors, only to experience disappointing returns or large losses. Studies consistently show this. I have written about this often in the past, and I will be writing about it more this summer.

Don’t get me wrong, I love the Internet. Wow, has it made my job as a writer and Investment Advisor easier (although I wish I could block more SPAM)! But the Internet and E-Banking and E-Investing are significantly changing not only how we invest, and how easily we can move our money from investment to investment (for good or bad), but they are also changing historical market relationships and correlations, as noted above.

Bottom Line: The Need For “Risk-Adjusted” Returns

As we watch the world change before our very eyes, with the Internet and all the miraculous changes that we will see in coming years, one thing will never change. We and all those to come will have to save more and invest wisely for our living-longer futures.

To save more and invest wisely, especially the latter, means that we will have to focus on minimizing investment losses. At my company, we focus on searching and finding professional money managers who have delivered impressive returns with less risk. We search the universe for money managers who have delivered impressive “risk-adjusted” returns, meaning they have had good upside returns with limited losing periods along the way. Past results are not necessarily indicative of future results.

The S&P 500 lost 44% in 2000-2002. The Nasdaq lost over 70%! That’s what happened to many “buy-and-hold” investors who finally jumped in the stock markets in early 2000 when it looked like stocks would go up forever. By the way, the S&P 500 has yet to surpass its record highs in 2000, now some six years later.

The reason we spend so much time and money seeking out money managers with good risk-adjusted returns is that I want to avoid losses like those experienced by buy-and-hold investors in 2000-2002.

If the recent nasty sell-offs in the markets have made you more sensitive to minimizing losses, then you may want to take this opportunity to check out the professional money managers I recommend by CLICKING HERE. As you look at their actual performance numbers, net of all fees and expenses, pay particular attention to what we call “Worst Drawdown” – their worst-ever losing period.

As you will see, the money managers I recommend have significantly lower losing periods than the market as measured by the S&P 500 or the Nasdaq 100 Index. Past results are not necessarily indicative of future results.

If you are interested, we have a list of FREQUENTLY ASKED QUESTIONS regarding the professional money managers I recommend, including how the programs work, what fees are charged, liquidity, etc., etc.

You may also want to look at our ABSOLUTE RETURN PORTFOLIOS. These are portfolios of carefully selected mutual funds that we offer to clients and prospective clients. We have selected mutual funds which have performed well in up or down markets. Here too, these portfolios of mutual funds were designed to minimize losses in down markets. Again, past results are not necessarily indicative of future results.

You are also welcome to call us for a free evaluation of your investment portfolio. My team of non-commission Investor Representatives will be happy to assist you with no obligation and no pressure whatsoever. Call us at 800-348-3601 or e-mail us at mail@profutures.com.

That’s all for this week. Have a great summer everyone!

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

New data suggests the economy is cooling.
http://biz.yahoo.com/ap/060605/economy.html?.v=4

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Stocks drop over oil & the economy.
http://quote.bloomberg.com/apps/news?pid=10000103&sid=aGR.eMKK5GI4&refer=news_index

Can Hillary Win Florida or Ohio in ’08?
http://www.realclearpolitics.com/articles/2006/06/hillary_cant_beat_50_against_a.html