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July 21, 2004

Midyear Economic & Market Review: More Disappointments Ahead?
by Douglas R. Gillespie

Foreword

In December, I wrote two articles outlining my thoughts about the course the economy and the financial markets would take during 2004. I make liberal use of these in the following material, as a convenient way of reviewing what has taken place so far, as well as examining what might be ahead of us.

In addition, the following discussion cites a good deal of data, which includes the use of several tables. For the most part, the tables are found in the appendix at the end of the missive. The applicable pricing for these is as of the close of business last Friday, 7/16.

Introduction

With regard to the stock market in particular, this year's first half had to be a disappointment -- to bulls and bears alike. However, when you consider the extraordinary ebullience in evidence as the year commenced, disappointment must be much greater among those in the bullish camp. And if January through June proved disheartening to optimists, the market's slide thus far in July certainly has done nothing to lift spirits. On the other hand, popular sentiment measures have remained quite buoyant. Thus, if my views about 2004's second half are in line with what comes to pass, the really major disappointments lie ahead -- but not for the bears!

In a nutshell, here is how I currently see the balance of 2004:

* Real GDP growth in the second half will come in at a rate of 3.5%, give or take, well below the 5% or even higher rate many continue to project.

* Crude oil prices are likely to reach higher than current levels during the second half, even in the absence of possible exogenous events creating supply interruptions. Were the latter to occur, $50/barrel West Texas intermediate crude would become a genuine possibility.

* Interest rates, across the yield curve, will continue to trend irregularly higher during the balance of the year.

* The dollar has rolled over and appears to be heading for a test of its early 2004 lows -- around 85 on the Dollar Index. If such a test proved unsuccessful, and the fundamental prospects for such an outcome are pretty good, a material break in the dollar's exchange-rate value would likely foster higher interest rates and lower stock prices.

* As for stock prices, I believe there is a good and growing chance the bellwether measures already have seen their 2004 highs. If so, there is also a good chance that for all of 2004, most equity-market proxies will record negative returns.

* The price of physical gold is poised for a strong second half. I would think that bullion visiting the $475 to $500 range by year-end is quite likely.

* Wall Street analysts are fond of avoiding incorporating exogenous events into their forecasts, sloughing them off as "unpredictable." And indeed, they are. But this certainly does not mean one cannot or should not assess the climate for their occurrence. In this regard, I remain pessimistic about new bouts of terrorism aimed specifically at Americans, and I continue to believe that domestic incidents represent a growing threat.

Past Months' Forecasts in Review

Before getting into more detail regarding the above forecasts, here is a collage I've woven from past research material published in December. This collage will set the backdrop for my midyear, mid-course adjustments.

It's time to have a look at what might be in store next year [2004] for the economy and the financial markets. First, however, a few comments about 2003 forecasts are in order. I'm absolutely delighted with how most of the opinions will have turned out. And best of all, they will have been right for mostly the right reasons!

In the dark days of earlier this year, when much of Wall Street was throwing in the towel, even to the extent of predicting new cycle lows and a negative year for the equity market, I vociferously stayed the course with a much more optimistic outlook. In this area, the year's watershed research missive was published on 3/18, carrying the title, "Do Stocks Have Life After War?" The conclusion was that they would have life -- lots of it, in fact. And they did! [However], the very upbeat missive of 3/18 was written by someone steadfastly in the secular bear camp at the time. The current offering is written by someone who maintains the same perspective!

[NOTE: The March piece provided a good amount of historical perspective on the secular bear stock market of 1965-1982. When you have a chance, I highly commend the missive to your reading or rereading. It appears in the "Archives" section of the website. It also can be accessed by using the following link "Do Stocks Have Life After War?".]

Right now, I would opine that 2004 could well be a year of unexpected outcomes that are the result of unintended consequences. And if outcomes are at all adverse for the economy and financial markets, they will indeed be unexpected. It is hard to remember the last time consensus forecasts were skewed so heavily towards the bullish.

The two areas I believe most likely to sprinkle at least some rain on the bulls' parade are inflation and interest rates. These are two areas on which Wall Street as a whole remains extraordinarily sanguine, but I have the distinct feeling that many forecasts for each are being "forced," so to speak, to make consensus predictions for the economy and the stock market appear a good deal more plausible than I believe them to be.

Around this time last year [in 2002], I thought it distinctly possible the US economy might evolve into something looking and feeling like stagflation during 2003. I was wrong about this, or at least wrong about the timing. If anything, however, I sense that this year [2003] has seen a reinforcement in the conditions that could lead to the stagflation outcome.

Bulls will likely take my earlier comment about "at least some rain" and remind me that present and projected conditions are so strong, they can easily withstand this level of harassment. But ... in many quarters, expectations for next year [2004] have been set so high that it is most unlikely they can/will be exceeded. In fact, I don't believe that at their current levels, these expectations can be met -- assuming nothing goes wrong. Therefore, on the margin, any problems that do develop along the way are likely to result in magnified disappointment. Considering how stocks are priced at present -- I'm assuming most of the expectations for next year are in current prices -- such a change in psychology could be surprisingly harsh in its impact on the equity market.

In the absence of a cataclysmic event, 2003 will finish soundly in the black ... I point this out because during the dog days of March, many analysts had capitulated to the view that 2003 would be the first time since 1929-32 that the stock market would decline four calendar years in a row. Many of the same folks, I might add, who are now assuring investors that additional large gains in stocks next year [2004] are a virtual certainty!

The environment I presently foresee for next year [2004] includes real economic growth well short of expectations, interest rates that rise across the yield curve, a dollar that continues to lose exchange-rate value, a stock market that is a good deal more troublesome than is currently expected, and a rise in the price of physical gold that is at least pari passu with bullion's 2003 experience.

The consensus forecast for real GDP growth in 2004 is now somewhere in the 4.5% to 5% area (year over year). My own view is that 3% to 3.5% will be more like it. To achieve the consensus number, personal consumption expenditures would probably have to grow by about $335 billion to $375 billion. I simply do not think the consumer will be capable of this magnitude of contribution.

Much of the benefit of this year's [2003's] tax cuts already have flowed through to consumption. There will be large refunds next year [2004] for certain filers, but I don't believe these will be sufficient to bridge the gap. Next year's likely interest-rate environment will not be conducive to the massive mortgage refinancing activity that added a lot of firepower to spending this year.

Highly stimulative monetary and fiscal policies are now kicking in not only in the United States but elsewhere, too. My guess is that this will lead to nominal growth rates in which inflation makes an increasing contribution. I can envision 6% or even 7% year-over-year nominal growth next year [2004], but where the split could be about 50-50. If you think this sounds at least a little like "stagflation," you will get no argument from me!

I presently anticipate that during 2004, the FOMC will hike the Federal Funds Rate by at least 50 basis points, and were the dollar's decline to become "disorderly" at some point, a greater increase in the Fed's administered short-term rates is a distinct possibility.

As to long-term rates, using the long Treasury bond (the 5.375s of 2/15/31) as a proxy, I believe we will see its yield rise well above 6% during 2004. At present, I would think something in the 6.25% to 6.50% range is entirely possible. A real danger for longer-term, open-market rates next year will be the possibility the Fed falls behind the curve (farther behind than it already is), then falls even farther behind because of a reluctance to hike rates for political reasons. The dollar would surely not prosper under such circumstances, either.

Using my seven-measure tracking group as a proxy, here's what the equity market looked like through yesterday's close for the year to date as well as from the October 2002 lows.

The above results are more than ample evidence that the optimism expressed by this secular bear during the dog days of March was more than justified.

I thought the stock market was entirely capable of reaching current levels, and I expressed this in the 3/18 piece referenced earlier ("Do Stocks Have Life After War?"). However, I thought current levels would be an event of sometime well into next year, since I also thought that on the way to these levels next year, there would be a sharp pullback in prices during 2003 that never took place.

I underestimated one Alan Greenspan. But I may have had some important company in this regard -- the President of the United States. In my mind, there's no question that Bush dangled the fifth term as Fed chairman in front of Greenspan last April to get Mr. G. to "flip" (euphemism for getting Greenspan to practice the world's oldest profession). It worked!

From a purely political perspective, it may actually have worked too well. Greenspan's immediate political subservience merely created another bubble. And this bubble has rather onerous timing dangers, vis a vis next year's elections.

We approach the end of this year which means the beginning of 2004 beckons, and I would guess a correction of something in the range of 15% to 20% in stock prices during 2004 is almost inevitable. Depending upon when and from what level it occurs, and what serves as its trigger, ... such a development could have very meaningful political ramifications.

...Street bulls, incessantly showcased on CNBC and in the other venues in the regular propaganda loop, now talk ... about "new [record] highs" next year. For most of the bellwether measures, this would be no mean trick. For instance, as of the close on 12/18, the S&P 500 stood 28.7% below its year-2000 closing high. To take this out would require an advance of more than 40%.

Worry not, though, since the magic of the "Presidential election cycle" is at work. And, yes, I do think there is something to the phenomenon, but before you take it to the bank, here are a couple considerations. (1) Historically, it by no means has been infallible, and (2) thanks to the behavior of the chairman of the Federal Reserve, most/all of this pump may already have occurred.

The most euphoric political assumptions -- regarding both the domestic and international arenas -- have found their way into the bond and stock markets. But "most euphoric" usually is at odds with "most realistic," which I believe is clearly the case at present. In my view, there are some serious potential problems that could evolve -- are even likely to evolve -- in the months ahead, and bonds and stocks are simply ignoring them at present. If so, the climate exits for rather sharp, unpleasant "attitude adjustments" in these markets.

New Ideas and Revisions

The Stock Market

I am jumping ahead to views on the stock market, since they likely represent the most radical of my ideas, vis a vis the consensus. The economic and interest-rate assumptions that underpin them come thereafter.

And in the stock area, the statement appearing earlier pretty much sums up where I stand:

"As for stock prices, I believe there is a good and growing chance the bellwether measures already have seen their 2004 highs. If so, there is also a good chance that for all of 2004, most equity-market proxies will record negative returns."

But before getting into more detail, I must reiterate a critical point, one I've made many times in the past. To wit: I remain a secular bear! I believe the bear market that began during 2000's first quarter, although now more than four years old, could have years yet to run. And while it is possible that the overall lows were made during the fall of 2002, it is likely that the 2000 highs will not be taken out for a long, long time. (See Table 1 in the appendix.)

Using my seven-measure equity-market tracking group as a proxy, here's what the year-to-date situation looked like as of the end of last week, as well as how the seven components shaped up versus their respective 2004 highs.

As opined earlier, first-half results didn't do great things for the bearish camp, but considering what the bulls' expectations were as this year began, it's the bulls that must be a good deal more disappointed. Not to mention that July so far has been pretty "rugged."

Much has been made about this being a Presidential-election year, as if there is something inviolate regarding Presidential elections and positive stock-market returns. There isn't!

Table 2 breaks out DJIA returns the year before and the year of Presidential elections going back to 1959-60. I have averaged these (the average of the two-year clusters runs in a range of 29.8% [1995-96], to 3.6% [1959-60]), then arrayed the 11 observations. The median of the arrayed data is 9.8%. Through last Friday's close, the combined DJIA 2003 and 2004 advance was 22.3%. Divide this by two and the result is 11.2% -- a figure 1.4% above the median. Nothing at all scientific here, but it is interesting! Moreover, in three of the 11 two-year observations that are broken out in Table 2, the DJIA declined in three of the years containing the election itself.

While, as stated earlier, there is no way to predict negative, exogenous shocks, one can assess given climates that might make them more likely than other climates. And in this regard, I remain highly concerned about new terrorist attacks against the United States. I believe the complacency exhibited by popular sentiment measures -- the CBOE VIX, for instance -- suggest the US equity market would take such an event very harshly.

The Economy

NOTE: Next week, the Commerce Department will render its advance estimate of second-quarter gross domestic product. I am using a 4% overall growth figure (annual rate) for the estimates appearing below, and my number is in line with the consensus. Were the number that is actually released to differ materially from 4%, it could throw off the following data a bit, but these are meant only as "big-picture" numbers anyway.

* I'm projecting that real GDP will grow 3.3% in the second half, measured on a Q4/Q2 basis. This second-half projection would result in fourth-quarter real GDP of about $10985.5 billion. In turn, this would see 2004 GDP come in at 3.6%, fourth quarter of 2004 over fourth quarter of 2003.

* In developing the above forecast, I have assumed that growth in personal consumption expenditures -- PCEs equaled 70.6% of total real GDP in the first quarter -- grew at a 3.5% annual rate in the second quarter, down a bit from the first quarter's 3.8% rate. I've backed the growth rate off to 3.3% during the third quarter, and to 3.2% during the fourth. This would result in fourth-quarter personal consumption at an annual rate of $7746.3 billion, 3.3% growth on a Q4/Q2 basis, and 3.5%, measured Q4/Q4.

* As I assess the situation, there are no other gross domestic product components, jointly or severally, capable of pulling overall GDP growth up to the 5% or higher rates many analysts continue to project. (See Table 3 in the appendix.)

Interest Rates and Related

* I continue to look for more increases from the Federal Reserve this year in the target rate on federal funds. My end-of-2003 forecast was for hikes of at least 50 basis points this year, 25 basis points of which occurred at the Fed's June policy meeting. The Federal Open Market Committee has two scheduled meetings before November's election -- on 8/10 and 9/21 -- and I believe it is a virtual certainty the FOMC will hike the fed funds rate a quarter point at least one of these meetings.

* It may not be a certainty, however, that there will be two rate hikes before the election, as was the growing presumption not long ago. Weakening economic data or higher energy prices could give the Greenspan-dominated Fed an excuse to drag its feet until after election day, thereby avoiding the probable ire of the Bush Administration. (Higher energy prices would raise inflation, but it also would create increased drag on the economy, creating the possible paradox.)

* I point out that while there is no FOMC meeting in October, there is one on 11/10, right after the election, as well as on 12/14. If inflation and/or the dollar behave as I believe one or both will, it is highly probable that federal funds will stand at 1.75% at minimum at year-end, and were either or both areas to get out of hand by later in the summer, the FOMC would likely be obliged to get the funds rate to 1.75% before the election on 11/2. (See Table 4.)

* As to long-term rates, I had forecast that the yield on the Treasury 5.375s of 2/15/31 would possibly make it into the 6.25% to 6.50% area sometime this year. And it still might, particularly if the dollar and inflation act up. However, I think it is prudent to throttle back my estimate somewhat to, say, 5.50% to 6%. From the Treasury 5.375's current level of around a 5.18% yield to maturity, even a 5.50% yield between now and year-end would produce a meaningfully negative total return. (See Tables 5 and 6.)

NOTE: I'm writing this after the market close on Tuesday, 7/20. Over the last hour or so, I've had Greenspan's Senate Banking Committee testimony on in the background. And he didn't surprise. It was the usual testimony for all seasons, something for everyone, with a distinctly bullish spin, of course. But one thing for sure, he is far more optimistic about energy prices and energy-driven inflation than I am, as he again referred to its effect in his newly acquired parlance of -- a "blip."

I will not overdo my usual speech on how the "official" inflation data have been so bastardized over recent years that they mean increasingly "little" (euphemism for something even less). More and more people are coming to realize this the hard way, by looking at the government's figures and trying to square them with their own experience. Still, even the bastardized government numbers may be reflecting more than the Fed head's "blip."

A couple weeks ago, give or take, when a barrel of West Texas intermediate crude got down to around $37, I said I thought that might be near a low. And it was, at least over the ensuing period. Today, the September NYMEX contract closed at $40.44, after a one-dollar decline, and even the December contract closed above $39.00. (See Table 7.)

Call me a skeptic, even a cynic. However, I still wonder if after you cut through all the recent bravado coming from Saudi Arabia, can the Saudis deliver all the extra oil they've promised. Doubts persist!

A final note on Greenspan's testimony today, which is that its upbeat tone helped batter long-term Treasury prices but rally stocks. The Treasury 5.375s fell almost a point, raising the issue's yield about 7 basis points, to 5.18%, while the DJIA rose 55 points or 0.5%, and the NDX rose 24 points or 1.7%. Meanwhile, the dollar had a good upward bounce in price, too. (See Table 8.)

But before bulls get carried way, the stock market was getting pretty oversold on a short-term basis, while the Treasury market was getting quite short-term overbought. So the markets were due for what they got. Let's see if today's spin session has staying power.

Domestic Politics

Very little on domestic politics now, other than to point out the obvious. Which is that the appearance of a tight Presidential race likely has ruffled the US financial markets a bit, owing to the uncertainty factor.

I plan on doing at least a couple more hypothetical interviews with George Bush before the election. As background, readers might want to peruse the first of these, which was dated 11/21/03 and is accessible in the archives or by using the following link "Thank You, Mr. President."

Table Appendix

Douglas R. Gillespie, Sr.
Gillespie Research Associates
165 Sheridan Avenue
HO-HO-KUS, NJ 07423
201-447-5743

Doug Gillespie oversees his own financial-market and economic consulting firm, Gillespie Research Associates. For a complimentary sample of Dougs material, e-mail him at drgillespiesr@aol.com.

Copyright © 2004-2005 Gillespie Research Associates. All rights reserved.

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