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Jeff Saut Presents: The Investing Twilight Zone


The 'Fox-Trot' Economy


Editor's Note: The following article was written by Raymond James Chief Investment Strategist, Jeff Saut. It has been reproduced with permission for the benefit of the Minyanville community.

January 3, 2006, The Wall Street Journal published its annual year-end survey of 56 leading economists and their forecasts for the year ahead. On balance the group was upbeat, suggesting the economic expansion would continue and that inflation would remain benign. "Continue" indeed, for the consensus estimate of the economists was for 3.5% GDP growth in the first part of the year followed by 3.1% growth in the back half. Consequently, what a surprise Friday's figures must have been to this group when the government's advance GDP growth figures were reported at a paltry 1.1% for the fourth quarter of 2005. However, after a few poignant moments, during which the talking heads were at loss for words, the spin doctors began their work. To wit, "if you exclude this or that figure from the GDP report growth would have been 3.5%." The whole scene was reminiscent of Herb Stein's (Ben Stein's father) remarks when he was chairman of President Nixon's Council of Economic Advisors. Said comments took place at a press conference where Herb Stein was asked by a reporter to explain why inflation was getting so high when he had not forecasted it. Without missing a beat Herb put on a straight face and said: "If you take out all the things in the Consumer Price Index that have gone up, the index would actually go down."

While Friday's figures were a shock for many, they were of no real surprise to us since we termed the U.S. economy the "fox trot" economy years ago, where like the dance fast/fast would be followed by slow/slow as the economy regresses towards a "muddle," but no recession. As repeatedly stated, we believe the U.S.'s year-over-year GDP growth rate peaked during 1Q04 at 4.7% and has been on a downward glide path ever since, interrupted at times by fast/fast figures. We have further opined that GDP growth was likely going to go sub-3% sometime in 2006. Obviously last week's GDP report was slow/slow, yet it will probably be revised upward in the months ahead. Indeed, fast/fast, slow/slow...

Manifestly, we agree with Doug Casey, who notes:

"On the one hand, discussions of the economy and the markets should be for amusement purposes only. Since it's impossible to know what the finances, motives, constraints, and desires of six billion people might be, it's impossible to know what they're going to do, or when. On the other hand, there is such a thing as human nature. Actions do have consequences. The madness of crowds exists. And both history and markets exhibit definite trends over time. Like many things in life, looking at the markets can lead you to paradox."

"When establishment economists prognosticate, their guesses are typically gussied up with convoluted theories and complex mathematical formulae. Their predictions are overwhelmingly bullish, partly because they're really just extrapolations of the prevailing trend, and partly because that's the politically savvy view to hold. This is not to accuse most economists of being idiots, even though I think most of their theories and formulae are idiotic. On the contrary, it's highly intelligent to be bullish – because throughout history things have always gotten better (albeit punctuated with setbacks, ranging in length and depth from the recent recession to the Dark Ages). Clearly, the longest trend in existence is the ascent of man, and it's likely to continue. Indeed, despite my cynicism on the world as it is, I think the ascent will likely accelerate."

Doug Casey's cogent comments are in keeping with our thoughts in that beneath the headline softer figures there remain hints of economic strength. Take unemployment claims, which were stronger than we had thought. Ditto, durable goods orders for December, for even as the major car companies were announcing massive layoffs January auto production improved by some 8%, according to Ward's. This alone should lift Industrial Production by some +0.4% in January. The result leaves us in agreement with the good folks at Gavekal, who suggested last week:
"If we are right in our view that consumer front-end of the U.S. economy is already slowing, the production back-end is bound to follow in the next few months. The only question, in our view, is when the firm evidence will emerge. Given the inevitable lags between events in the real economy and the publication of statistics, the earliest date to expect conclusive evidence of a slowdown is probably mid-March. These lags mean that the Fed is almost certain to raise interest rates to 4.75% at Ben Bernanke's first meeting in the chair on March 28th and quite likely to follow with a further tightening to 5% on May 10th. This degree of tightening is not yet discounted in the markets and would produce a steeply inverted yield curve if the 10-year yield stayed anywhere near its current level of 4.3% (our premise). The upshot could be a pretty ugly situation for all cyclical assets, with statistics unexpectedly weakening, corporate earnings sure to follow, the Fed over-shooting, and the bond market apparently pointing to recession."

"In our view, such anxiety about recession will turn out to be a head-fake, since the low level of bond yields and inverted yield curve will be a function of the Asian savings surplus, rather than cyclical-concerns. But that is only our opinion. In all likelihood, the permabears would come out of hibernation in response to weak
U.S. figures and would gain far more attention with their roaring predictions of recession, than we could possibly attract with our more subtle views about a mid-cycle slowdown and a rebound in 2007."

"In short, the summer should present some excellent buying opportunities for equity investors, but first we expect to see some bad news on the economy, attacks on Bernanke for overdoing the monetary tightening – and a market correction of more than a few percent."
Unfortunately, these views currently leave us in the trading/investing twilight zone, sensing that while stocks may trade higher in the near term, they are in the process of making a trading top of some significance in the intermediate term. And, evidently the folks at the Lowry's organization agree, given the special strategy report they issued on Friday titled, "An Exploration of the Nature of Bull Market Tops." If you want to know where the secular "bull market" exists, it is (in our opinion) where Richard Russell suggests – "throughout the history of capitalism, we've experienced bull market cycles of financials (stocks and bonds) alternating with bull market cycles in tangibles (commodities . . . aka "stuff") and then back to financials." We think there remains a secular bull market in "stuff" and consequently continue to be buyers of "stuff" on weakness, preferably those situations with yields. Raymond James' Canadian research universe of stocks is littered with ideas along this line. Unsurprisingly, our friends at Concierge Investing agree (, having recently written that, "Canada is the only country with both a federal budget and current account surplus, which has the lowest total government debt-to-GDP ratio; and Canadian interest rates are well below those in the U.S. because of the slower pace of inflation. Canada is also in the center of a commodity boom and the world is finally taking notice of our thriving energy sector." Clearly, we agree and continue to invest accordingly.

The call for this week: We have been WRONG on interest rates since they have traveled higher than we envisioned, yet we believe they will they will continue to trend higher. Also of interest is that on December 27, 2005 the DJIA hit 10932 and that 30 days later (last Friday), despite all the hoopla, the high-water mark was also at 10932. Moreover, the NASDAQ 100's (NDX) January 19th's intraday reversal high was at 1727 only slightly above last Friday's intraday high of 1724. Given the NDX's make-up, we find our semiconductor analyst's (Ashok Kumar) comments to be particularly cogent in that, "The fact that companies are missing their own guidance (mid-quarter at that) reflects uncertainty in end demand. Operating earnings growth for the semi-companies has largely peaked and will likely stabilize at levels in-line with the long-term trend growth for the market, or high single digits. With largely negative revisions to earnings, these stocks are likely to end the year at no better than current levels." While we are sanguine regarding the current investment environment, if you want to commit capital here we suggest considering a number of our Canadian ideas, which we will discuss in our verbal strategy comments tomorrow. We also continue to like the MFS International Diversification Fund (MDIDX). Simply stated, MFS has combined five of its existing international funds, as well as their respective portfolio managers, into one fund. That fund allocates internationally, diversifies across market capitalizations, styles, sectors, and countries, while automatically rebalancing the overall portfolio periodically. In the process it checks all of the Morningstar Style Boxes that we consider necessary.


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