Why The Economy Could Disappoint In 2006
Forecasts & Trends

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There is a consensus that January was a very strong month in the economy, following a weaker than expected 4Q. Perhaps the biggest reason for the strong showing in January was the weather. January 2006 was the warmest on record according to NOAA. As a result of the warm weather, malls and shopping outlets were brimming with customers, and construction boomed in most parts of the country.

Based on the stronger than expected economic reports for January, most economists and market analysts are raising their estimates for 1Q GDP. Some now believe the economy will grow by 5% or more in the 1Q. Should this prove to be true, we could see more interest rate increases from the Fed than are currently expected.

Yet with January being so much stronger than expected, are we in for a disappointment when the February numbers come in? I think so, and the few reports we have for February seem to bear this out. Plus, the weather was much colder in February, with a blizzard in the Northeast.

So while many economists are raising their economic forecasts based on January reports, we could see them revising those estimates back down again by the end of this month when we will have seen most all of the reports for February. In short, economic growth for the 1Q, while it will be positive, may not be as good as presently expected.

In this E-Letter, we'll look at the recent economic reports, inflation reports and the data on consumer confidence and spending to try to make sense of upcoming trends. I will also give you The Bank Credit Analyst's latest thinking on the economy, interest rates and stocks and bonds.

As you will read below, BCA expects another very volatile year in the stock markets. If they are correct, you may want to consider investing in mutual funds that have a history of delivering positive "absolute returns" in up OR down markets. There are some mutual funds that have done that. I'll tell you more about them as we go along.

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Economy Rebounds Strongly In January

On January 27, the Commerce Department issued its preliminary estimate of 4Q GDP, showing that the economy grew at an annual rate of only 1.1% in the last three months of 2005. That report was a shocker since the pre-report consensus was for a rise of nearly 3%. Last week, the government revised 4Q GDP from 1.1% to 1.6%, still well below where expectations had been.

Despite the much slower than expected 4Q, there was some good news in January. Perhaps due to the mildest January on record, consumers were in a good mood. Consumer confidence jumped 2.3% in January. Personal income was up 0.7% in January, and up 4.0% for the 12 months ended January. Consumer spending rose 0.9% in January, the best in six months.

Retail sales were up 2.3% in January, and up 8.8% for the 12 months ended January. The Index of Leading Economic Indicators rose a solid 1.1% in January.

Most surprising of all, housing starts jumped a whopping 14.5% in January. No doubt this was due to the unseasonable warm weather across much of the country. On the flip side, sales of new and existing homes decreased in January. Sales of existing homes have now declined for five consecutive months. Durable goods orders were down sharply in January, but this was largely due to large aircraft orders that reportedly were delayed until February.

The unemployment rate fell to 4.7% in January, down from 4.9% in December. The unemployment rate has not been at 4.7% since July of 2001, prior to the 9/11 terror attacks. Average hourly wages rose 3.3% for the 12 months ended January, the largest change in over three years.

Economists cited two main factors for the large spending increase in January: warm weather and gift cards. This January was the warmest on record, according to the NOAA National Climatic Data Center in Asheville, North Carolina. In the fair weather, consumers returned to stores to redeem billions of dollars worth of gift cards. While the cards were purchased in the weeks and days leading up to the holidays, it is not until they are redeemed that they are recorded as actual sales.

On the inflation front, news was not so good. The Consumer Price Index rose 0.7% in January, higher than expectations; however, the "core rate" -- minus food and energy -- remained at 0.2%. It is supposedly the core rate that the Fed focuses on, but I can't imagine chairman Bernanke is happy that the CPI was up that much In January (more on this later). In addition, wholesale prices rose 0.3% in January following a 0.6% rise in December.

While the economy stalled somewhat in the 4Q, with GDP rising only 1.6% (annual rate), it certainly appears that growth rebounded strongly in January. With the positive news noted above, many economists are revising upward their forecasts for 1Q growth. Several analysts have raised their estimates of 1Q growth to 5% or above.

February Not Looking Good So Far

While economists and investors alike were reassured by the strong numbers in January, it looks like February will have been a disappointment. We don't have a lot of economic data for February yet, but we know that consumer confidence fell significantly last month. The Conference Board's Consumer Confidence Index fell from 106.8 to 101.7 in February.

The University of Michigan's Consumer Sentiment Index for February fell to 86.7, down from 91.2 in January. It is still not clear exactly what caused the drop in consumer confidence last month. Maybe it was weather, maybe is was political developments (UAE ports deal, etc.), or maybe it was a combination of both.

The ABC News/Washington Post Consumer Comfort Index in mid-February showed that only 17% of respondents believe the economy is improving. Consumer confidence is an important indicator since it affects consumer spending, which accounts for almost 70% of Gross Domestic Product.

And so it was with retail sales. In February, 60% of chain stores fell short of sales expectations following the strong surge in January. Specialty apparel was especially hard hit in February with sales falling 1% versus a year earlier, when they had been expected to be significantly higher than in 2005. The unemployment rate for February will be released on Friday, and early estimates suggest the rate will rise from 4.7% in January to 4.8% for February.

On February 12, a major snowstorm hit the Northeast and record breaking cold swept through most of the Midwest. This undoubtedly affected consumer spending, but it remains to be seen if the drop in consumer confidence and spending last month reflects a trend, or is merely just a weather-related correction.

Most of the economic reports for February have yet to be released, so it remains to be seen if the economy cooled significantly last month. But the early reports don't look too good. As I will discuss below, I believe there is a good chance that the economy will come in below expectations for all of the 1Q. If the economy slows in February and March, the 1Q could see growth of only 2-3%. I could be wrong, of course, and as noted above, most analysts are predicting growth of 4-5% for the 1Q. We'll see.

More Fed Rate Hikes Expected

The combination of strong economic numbers and higher than expected inflation in January suggest that the Fed will raise interest rates at least two more times. Most analysts now believe the Fed will raise short-term rates by another 25 basis points on March 28 and again on May 10. That would put the Fed Funds rate at 5%.

The big question now is whether the Fed will raise rates a 17th consecutive time to 5.25% on June 29 when the FOMC gathers for the fourth meeting of this year. Based on the strong economic reports for January, more and more analysts are expecting a 17th rate hike in late June. On Friday, for example, Lehman Brothers raised its Fed Funds target from 5% to 5.5%.

However, if the economy slowed modestly in February, as the early reports suggest, and if growth is somewhat subdued in March, as I expect, then there is a very good chance that the rate hiking cycle ends either with the March 28 increase or the May 10 increase.

FYI, the yield curve was as follows as of Friday: 3-month T-bill 4.60%; 2-year T-note 4.75%; and 10-year T-note at 4.69%. To me, those numbers read "FLAT" but we will no doubt continue to hear warnings about the inverted yield curve. Certainly, the Fed will be watching the yield curve closely as it makes its policy decisions in the weeks and months just ahead.

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BCA's Latest Thinking

In a nutshell, the editors at BCA believe that the economy is going to slow down this year after surprising on the upside for the last several years. They believe that three primary factors -- falling home prices, high energy prices, and the need to increase savings -- will result in a modest reduction in consumer spending, which will result in a modest slowdown in economic growth over the next 2-3 quarters.

While the editors believe that the US economy is still in the midst of a "long-wave upturn" which could last another decade or so, they believe that the three factors noted above (plus others such as rising short-term interest rates) will cause the US economy to take a breather this year. While they don't put an exact number on it, they do say they expect growth to moderate to a level below 3% in the months ahead.

BCA does not believe we are headed for a recession this year or next year. They merely believe that we will experience a period of slower than expected economic growth over the next 2-3 quarters. In this scenario, the editors believe that inflation will slow down, and the Fed will not have to raise the Fed Funds rate above 5% later this year.

BCA expects the bull market in equities to continue this year, but they do not believe that returns will be exciting. They use the word "grind" to describe the likely pattern in the stock markets, with lots of ups AND downs along the way to moderately higher prices overall. BCA believes that equities will outperform bonds in 2006, and as a result, they recommend slightly higher than average holdings of stocks and lower than average holdings of bonds. They say:

"... as long as we are correct that the Fed will soon put a halt to rate increases, then the odds are good that equity prices will grind their way higher over the course of the year. It probably will not be a great year for returns, but stocks should beat both bonds and cash, warranting a modestly overweight position."

BCA believes the US dollar will resume its long-term downtrend in the months ahead. BCA says:

"The dollar outlook will be driven by expectations about the relative performance of the U.S. economy and by the relative stance of monetary policy. On both grounds, it is reasonable to expect the dollar to decline. There is increasing optimism about the growth outlook for Japan and the Euro zone, and expectations about the U.S. are likely to be revised down in the months ahead."

I would suggest that the US dollar peaked last November, and the strength we have seen since late January has presented another short-selling opportunity.

The Need For "Absolute Returns"

For over a year, I have been emphasizing "absolute returns," investment programs and funds with the potential to make money in up OR down markets. If BCA is correct, we're in for another very volatile stock market again this year. The stock markets may well go modestly higher this year, but as we've already seen, the ride will likely be a wild one!

For this reason, I would recommend that you consider our Absolute Return Portfolios. After significant research and analysis, we have put together groups of mutual funds that have a history of performing well in up or down markets. (Past results are not necessarily indicative of future results.)

In addition to my company's analysis of active money managers, we also have access to mutual fund databases and analysis programs. This sophisticated software allows us to evaluate the performance of all mutual funds, and to select, among the thousands of alternatives, the ones that our analysis shows to have the best potential for ongoing absolute returns with limited risk.

Instead of looking for the latest "hot" funds, we focus on funds that have a history of producing absolute returns in both rising markets and falling markets.

My clients know the fallacies in chasing the latest "hot" funds. So what we looked for among the thousands and thousands of equity mutual funds were those funds that I would characterize as "Steady Eddie" funds -- those that have delivered good returns (although not necessarily the highest) through various and different market environments -- with limited drawdowns.

With our serious commitment to technology, we have software in-house that allows us to search the universe of mutual funds using virtually any selection criteria we choose. We can "dial-in" those funds that meet our specific performance requirements.

Once a number of potential candidates are identified, we then run various combinations of these funds inside a single portfolio, in an effort to further enhance potential performance and reduce the risk of loss. We call these different groups of funds our Absolute Return Portfolios.

All of the mutual funds we have selected have some measure of active management as part of their strategies. Investors who wish to take advantage of the Absolute Return Portfolios will have the choice of three different risk levels -- Moderate, Moderate-Plus and Aggressive. There is a slightly different mix of funds (5-6) in each category, but the objective is to produce attractive absolute returns.

We continually monitor the funds making up each Absolute Return Portfolio, and we have the authority to add, drop or replace a fund within a particular Portfolio, should that become necessary in the future. Factors that might cause a fund to be dropped from a Portfolio include, but are not limited to: the loss of a key manager, regulatory problems, change in the investment strategy, or poor performance. (As always, it is also important to remember that, while these funds have posted consistent positive returns in the past, there is no guarantee that they will do so going forward.)

How To Take A Look

I suggest you start by reading my latest Absolute Returns Special Report. You really need to do that if you are serious about investing in today's very volatile stock markets. This Special Report will help you understand why we recommend the investment programs we do, and how we select them.

The next step is to contact us for the specific information on the fund portfolios. There are several ways you can do that. You can call us toll free at 800-348-3601 and one of my trusted Investor Representatives will be happy to send you information, with no pressure or obligation. Or you can e-mail us at mail@profutures.com. Or you can also click HERE to immediately access our online information request form -- be sure to read all the important disclosures.

The minimum required to fully invest in our Absolute Return Portfolios is only $15,000. Individual accounts are opened at Ameritrade (formerly T.D. Waterhouse) where the funds will be purchased and held.

To learn this valuable information, and get started, you will have to take the next step and become one of my clients. It doesn't matter where you live, or that we have not met in person. I have clients in all 50 states, most of whom I have never met.

There are several ways you can initiate this easy process. I am very excited about our Absolute Return Portfolios and their potential benefits for investors at most any level, including even younger investors who may just be starting out. The programs are also available for IRAs, trusts, etc.

Given the numerous forecasts for another choppy year in the stock markets, now may be the time that you bite the bullet and see if we can help you experience some acceptable returns.

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Conclusions -- Another Dicey Year>/p? Indeed the economy rebounded strongly in January, following the disappointing 4Q which saw growth of only 1.6% (annual rate) in GDP. In light of January's numbers, most economists are revising their growth forecasts for the 1Q. Some now believe the economy will grow by 5% in GDP during the 1Q.

But it is becoming increasingly clear that much of the strength in January was due to the warmest weather on record. Consumer confidence was up, retail sales were strong, and housing starts exploded. Yet the good weather did not continue in February, and the early reports for last month look mostly disappointing. Consumer confidence fell sharply in February, and retail spending was disappointing.

The Bank Credit Analyst believes the US economy will see a period of 2-3 quarters in which growth will disappoint. No recession, mind you, but GDP growth that should slow to slightly below 3% (down from 3.5% in 2005 and 4.2% in 2004). BCA believes stocks will outperform bonds this year, but warns that it won't be a smooth ride. BCA believes the US dollar will resume its long-term downtrend this year.

With the equity markets expected to remain very volatile again this year, with only modest gains, now may be the time for you to consider our Absolute Return Portfolios. I invite you to contact us to learn which mutual funds made it into our portfolios by making money in up AND down markets. (Past results are not necessarily indicative of future results.)

Finally, I am happy to report that Third Day Advisors, which I discussed at length last week, had another strong month in February -- when the S&P 500 was sideways and the Nasdaq actually went down. For more information on Third Day, click HERE. (Past results are not necessarily indicative of future results.)

Wishing you profits,

Gary D. Halbert

Gary Halbert is the president and CEO of the ProFutures companies, a diversified investment advisory firm located in Austin, Texas. ProFutures offers professional financial planning services to a nationwide base of clients. Mr. Halbert's firm specializes in tactical investing, and its recommended investment programs include mutual funds, managed accounts with professional Investment Advisors and alternative investments. For more information about the programs offered, call 800-348-3601 or visit the website at www.profutures.com.


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Copyright © 2006 ProFutures Capital Management, Inc. All Rights Reserved.


"Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc. are not affiliated with nor do they endorse, sponsor or recommend any product or service advertised herein, unless otherwise specifically noted."

Forecasts & Trends is published by ProFutures, Inc., and Gary D. Halbert is the editor of this publication. Information contained herein is taken from sources believed to be reliable, but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgment of Gary D. Halbert and may change at any time without written notice, and ProFutures assumes no duty to update you regarding any changes. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Any references to products offered by Halbert Wealth Management are not a solicitation for any investment. Such offer or solicitation can only be made by way of Halbert Wealth Management’s Form ADV Part II, complete disclosures regarding the product and otherwise in accordance with applicable securities laws. Readers are urged to check with their investment counselors and review all disclosures before making a decision to invest. This electronic newsletter does not constitute an offer of sales of any securities. Gary D. Halbert, ProFutures, Inc. and all affiliated companies, InvestorsInsight, their officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Securities trading is speculative and involves the potential loss of investment. Past results are not necessarily indicative of future results.

Posted 03-07-2006 5:44 PM by Gary D. Halbert