Wednesday, May 2, 2007

Midweek Economic Report

The Dow Jones Industrial Average surpassed 13,200 for the first time today, after a report on U.S. factory orders generated strong investor enthusiasm and optimism about the economy. The Dow gained more than 75 points and reached its second straight record close. The Commerce Department reported orders to U.S. factories rose 3.1 percent in March. This was the most robust in a year, led by strong demand for commercial aircraft. This increase was much higher than the 2 percent rise many analysts had been anticipating. The report was accompanied by a sharp increase in the level of business investment. The Labor Department will be reporting on March job creation and unemployment on Friday, and investors will be eyeing this report, as well corporate profits. All of this information will be dissected in an effort to ascertain how rapidly the economy might be slowing and whether earnings reports, which for the most part have beaten expectations, might continue to give stocks a lift. With the direction of the economy by no means certain, the competing scenarios of inflation or economic slowdown, which we've discussed since last year, still ring true today.

The term used by economists to describe what seems to have happened at this juncture is a mid cycle slowdown. With the initial first quarter GDP growth reported on Friday at an anemic 1.3%, and with the reports concerning factory orders and business investment reported today, the conclusion one could draw is the economy bottomed in the first quarter. If this is the case, it implies there may be quite a bit more life in the current expansion. The stock market, which is a leading indicator, seems to be signalling higher highs are in the future. If this is a true mid cycle slowdown, it would be very positive because it helps to ease concerns about inflation, which in turn could mean the Fed will continue to hold interest rates steady.

In all fairness, it is important to point out this bullish outlook is not shared by everyone. While some of the statistics can give one a true dose of optimism, there are those who look at the weaker dollar, the housing slowdown and the endless use of leverage in the financial system as a harbinger of bad times to come. Those in the bear camp tend to feel the stock market is overly optimistic about an economy that has slowed substantially and will continue to do so in the face of ever mounting pressure on consumers, due to decreasing home values and the inability to refinance mortgages with ever increasing monthly payments. According to Alan Abelson, the fabled writer for Barrons and the quintessential bear, "We think the economy will slide into recession, as the drag from housing and unprecedented consumer debt make themselves increasingly felt. We think the dollar will continue down the slippery slope, complicating Mr. Bernanke's life and inducing slumpflation. We think this overleveraged, overheated, overhyped market will blow itself out and touch off a chain reaction that'll rock global bourses. And all this will happen, if not tomorrow, then soon enough, we're afraid." These are some very sobering thoughts to ponder as we march toward Dow 14,000. I am relatively sure that number will not reached in the scant six months it took to go from 12,000 to 13,000. But then again, you just never know!

So how does one deal with the starkly different opinions about the direction of the economy and the markets? Well, you could sit on the sidelines in cash. The problem with that is, you just never know when it is safe to jump back into the market. I think it is better to have a disciplined, diversified, long term approach to investing. You should use a mix of cash, stocks, bonds, mutual funds or ETF's, commodities and real estate at a comfortable level of risk for YOU. This diversification can help protect you from the gyrations of one or more asset classes, when they fall out of favor. There are many risks lurking out there in the world to upset your apple cart. While you can't protect yourself from every risk to your portfolio, the more diversified your assets, the better chance you have of riding out the financial storms you'll encounter.

John Kaighn