The Outlook for 2003

The economy is suffering from consumer burnout and the impact of higher oil prices. With the Venezuela problems unresolved and the threat of war with Iraq, the price of oil is going to be a problem for the recovery. While Saudi Arabia can increase output of oil for a period of time, its ability to sustain higher levels of output are limited. Other producers are already close to capacity so that continued problems in Venezuela and any disruption from Iraq could result in a worldwide recession.

The outlook for the year is not encouraging. The Federal Reserve has little room to lower interest rates to encourage business investment. Oil prices are likely to remain high, acting as a tax on consumer spending. The state and federal deficits and efforts to raise taxes will also temper spending by business and consumers. The Bush economic recovery program offers some hope; the devil is in the details.

With interest rates already low there are few options available to the Federal Reserve to boost economic growth. Lowering the discount rate further is unlikely to increase business investments or home sales or home refinancing.
Market rates did not respond to the last cut, and any further cuts are unlikely to make much of an impact on investments or home buying. An increase in the money supply, the other Fed tool, could result in inflation problems.

Even if the Purchasing Managers Index indicates a recovery in the manufacturing sector, it does not insure additional investment. There is still excess capacity that needs to be worked off before we can expect a significant increase in business investment. The consumer has cut back on spending, if the Holiday season sales reports are to be believed, which would offset any improvements in capital investments.

The Bush economic stimulus package offers some hope, but rather than tax breaks it would be better for the economy if the government were to invest in infrastructure projects. Extended unemployment benefits and aid to states to
create jobs will keep the economy growing, albeit at a slow rate.

It is unclear on how the proposed elimination of the tax on dividends will work. If the tax on dividends is treated as a cost of capital to the company (deductible to the corporation as a cost) and taxed at the individual level, it
may just shift sources of financing from debt to equity over time, with little impact on the operation of the company. If it is exempt from taxes at the individual level it will primarily benefit the wealthy, and the loss of tax
revenues will more than offset any benefit from additional spending. If a portion of the tax on dividends to the individual is exempted from taxes, say several thousand dollars, it will probably have a positive but limited impact
on the recovery.

Overall the risk of a continued weak recovery appears much more likely than a hoped for robust recovery in jobs or profits. The excess of the 1990s take time to be worked off and that is likely to take more time.

The Stock Market

The stock market got off to a surprising start this month. Perhaps the hope of a January effect will somehow make all the economy’s problems disappear. Both the Santa Clause rally and the January effect are based on historic data. The problem is that the stock market has always trended upward, representing a
combination of economic growth and inflation. Given that trend it would be unusual to have stocks not rise in December and January. If you examine the trend of the market relative to the economy, the correction in the market is not over unless some miraculous growth in the economy should occur.

If the Bush stimulus package exempts dividend from taxes, dividend-paying stocks should be a good investment. As we have seen though, even stocks that were once considered to have safe dividends like utilities have surprised. In
picking such stocks be wary.

I expect one more testing of the lows. Hopefully, the market will not break through these lows. If it should, the market could correct even further.