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No Boom, No Recession

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The most likely bottom line for the economy is for no boom, no recession, but continued sustainable, if modest, growth.

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Note from Professor Vitaliy: The writer of this piece, Michael Conn, is a president and founder of Investment Management Associates, Inc. He is a Chartered Financial Analyst and has been in the investment industry since 1968. Michael and I work side by side and look at the world in a similar way, the only difference is he's been doing this a bit longer (ok, he has ties older than me).

Stocks rose modestly in the first quarter, and bonds declined as interest rates rose.

The much-feared inversion of the yield curve seems to be fading away as ten year treasury yields have climbed above short-term rates. The Fed bumped rates again to 4.75%, the first action under Mr. Bernanke. The increase was widely expected, but the markets were disappointed by the lack of any indication that this might be the end of the rate increases. The tone of the Fed's comments was directed more to concern over rising inflation pressures than any slowing of the economy. The recent strong employment gains are central to the Fed's concern, as labor costs impact the inflation numbers more than commodity prices. Slower business investment since the 2001 recession calls into question continuation of the productivity gains which have offset higher wages. We expect business spending to strengthen going forward.

We, along with many others, have been concerned that rising interest rates, high gas prices, and potential declines in real estate values would significantly depress consumer spending. Thus far, the employment gains (more paychecks) seem to have offset these negatives to the extent that consumer spending has not significantly declined. Interest rates are likely to continue upward somewhat, but not enough to have a dramatic impact on spending. The real estate market has softened, especially in previously hot areas where there was a lot of speculation. Many of these speculators will get burned, and aggressive lenders will find themselves taking title to properties, but over the whole economy, the real estate influence is likely to be more in the nature of a soufflé rather than a balloon.

Oil prices depend on so many unpredictable geo-political variables that we have no confidence in predictions of either higher or lower levels. The facts are they are higher than last year and definitely act as a tax on the economy. Further significant increases would likely result from supply problems rather than increased demand, and while negative for the economy, and for the rate of over-all inflation, would not cause the Fed to tighten. Fed policy is oriented to demand, not supply. Oil prices high enough to demonstrably slow the economy might be met with Fed stimulation.

The most likely bottom line for the economy is for no boom, no recession, but continued sustainable, if modest, growth.

Early in an economic expansion, earnings estimates tend to be too conservative and are raised as results come in. As the expansion matures, this changes, and we believe we are at the stage where earnings estimates early in the year are too optimistic and are likely to be lowered as reality intrudes on expectations. In this type of environment, we would expect investor interest to migrate to the quality large-capitalization issues which have now lagged the market for, in many cases, several years. These companies combine historically modest valuations with the potential for dividend increases. We look for a stock market trading in a fairly narrow range, but believe these stocks offer the best combination of low risk and potential return.

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No positions in stocks mentioned.

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