RECOMMENDED ASSET ALLOCATION

This investment advisory believes in adjusting the asset allocation of a portfolio in order to minimize the volatility of its returns. The recommended asset allocation reflects the current risk level of the markets. As of 1/23/98 our proprietary indicators suggest your funds should be invested as follows:

These percentages should be interpreted as the probability that each asset will outperform the others. The higher the probability, the higher the risk adjusted return offered by a specific investment.

The recommended asset allocation is only a guideline and should be adapted to your personal objectives.

RECENT DEVELOPMENTS, FORECASTS, STRATEGY

Stocks continue to trade in a broad range above important support levels. Volatility is declining. But momentum is waning and is negative.

Short-term interest rates (T. bills) remain close to 5%. Real interest rates are too high. Is the Fed too tight?

Bond yields remain below 60/o. Inflation is only 1.7%. Real bond yields are still high.

Commodities continue to be broadly weak.

Foreign equity markets follow the tune of the US market .

The US economy is growing at a strong pace. The yield curve continues to flatten. The money supply is expanding at a solid clip.

This is a summary of our forecasts. A detailed discussion and analysis of current developments and review of the model portfolios is found in the following pages.

• The long-term outlook for stocks remains bullish.
  
  
• The intermediate-term outlook has turned negative.
  
  
• Short,-term interest rates (T. bills) are likely to stay close to 5%.
  
  
• Bonds are unattractive.
  
  
• Foreign equity markets are unattractive.
  
  
• The trend of inflation and commodities is down.
  
  
• The money supply will continue to accelerate.
  
  
• The yield curve (less than 5 year maturities) will continue to flatten.
  
  
• The dollar will trade in a broad range.
  
  
• The economy will remain strong.
  

Although our fundamental indicators remain very bullish for the long-term, market momentum has turned negative. When this happens, it pays to become more conservative and raise cash.

For this reason we recommend you sell 10% of your domestic stocks and all your energy stocks because of continued weakness in oil. By doing so you will reduce the volatility of your portfolio and still participate with 50% of your capital in a rising stock market. If momentum deteriorates further, we plan to sell more stocks.

At this particular juncture we are going to let our indicators tell us what to do. Right now they are turning negative. If they change, we will change.

We are very pleased to report Forbes placed us on the "honor roll" of only 5 Investment letters for our "ten-year record of excellent performance in both up and down markets" (January 1998).

THE US STOCK MARKET

Indicator review. The Dow Industrials remains below the peak reached last August. The S&P 500 topped in November as volatility soared. There is no doubt the action of the main averages suggests the environment has deteriorated and risk has increased.

In the last few months the market has lost considerable momentum, as measured by the percent of above their 30-week moving average. This gauge fell decisively below the crucial 55% mark, suggesting stocks have entered a difficult period in the intermediate-term. It is time to become more cautious.

Another worrisome trend is trading volume which has been declining since last November. It is very difficult to justify much higher stock prices unless volume picks up in a more visible way. The good news is volume has expanded in the past several days.

On a positive note, volatility is declining, suggesting investors are less apprehensive about the future.

What about the long-term outlook?

Our fundamental indicators remain solidly bullish, with 6 of them positive and only 2 bearish. These are the bullish indicators.

• Commodities are weak, pointing to lower inflation and a strong market
  
  
• The utility group still points to a strong market.
  
  
• Bond yields are declining and are still below their 26-week moving average.
  
  
• The rate on 13-week T. bills is close to 5%.
  
  
• Liquidity is favorable.
  
  
• The yield curve continues to flatten, as we predicted.
  

The two bearish indicators reflect negative credit demand and market overvaluation.

As you can see, the fundamental forces are very powerful. But can the market go much higher?

The answer lies in the current level of interest rates and earnings. In the past 15 years, when T. bills, 5-year and 10-year bonds were at the same levels as today, the market was overpriced when the PE rose to about 25. At the current level of earnings ($40.64) the overvalued level for the S&P 500 is 1016, which is obtained by multiplying the PE of 25 by current earnings of $40.64.

In other words, if earnings do not grow and interest rates remain reasonably close to current levels, the upside potential for the market is about 7%.

If you assume, and this is not unreasonable in a strong economy, that earnings will rise 50/o, the upside potential for the market is an attractive 12%. This means the Dow could rise to 8600 from the current 7700 level.

Long-term outlook. We remain long-term bulls with an upside potential for the market of about 10% from current levels.

Intermediate-term outlook. The serious loss of momentum has flagged signs of caution. The intermediate-term trend has become negative.

Short-term outlook. Our proprietary short-term trading is bullish.

FOREIGN EQUITY MARKETS

Indicator review. A book written by Paul Krugman in 1994, three years before the facts, explains why "the Asian miracle" could not last. He suggested the strong growth of the Asian emerging countries was a one time affair caused by a massive transfer of labor and capital to the production of goods.

However, what could the emerging countries do for an encore? Once everybody is employed, growth can materialize only from improvement in productivity. After all, economic growth is equal to productivity growth and growth in the labor force.

In 1994 Paul Krugman suggested it was very unlikely for Asian productivity to continue to grow at the same torrid pace of the previous decade. Therefore a slowdown was probable, according to the economist. One of the failures of the policy makers was not to invest in processes and infrastructure crucial for increasing productivity. This is one of the major causes of the Asian debacle.

A similar slowdown occurred in Japan. Its strong economic growth of the early 1960s started to wane toward the 1980s when productivity growth began to come closer and closer to US manufacturing productivity growth.

The other main reason for the Asian crisis, besides the obvious lack of financial transparency, is what we discussed in previous issues. Recent research confirms our assessment. The Asian politicians tied their currencies to the dollar without matching it with adequate monetary policy. Result: their currencies collapsed.

In the industrialized countries short-term interest rates are still above their cyclical lows of last summer. However, short-term interest rates continue to decline in Italy.

Foreign bond yields continue to decline 'm all countries, reflecting a flight to quality from emerging countries to industrialized ones.

The dollar declined to DM 1.81, still below the peak of DM 1.86 reached last August.

Outlook. Foreign equity markets were weak and will be weak. They remain unattractive as an investment option.

Investment strategy, Avoid foreign equity markets.

The money supply (M2 and M3) is accelerating, pointing to an even stronger economy ahead. We are also convinced that once Asia stabilizes, all the liquidity which has been printed to bail out the Asian countries will translate into very strong growth and higher inflation.

THE GROWTH CYCLE AND YOUR INVESTMENTS

Indicator review. Beware of a strong economy. Why? Because a strong economy siphons money away from the financial markets, making them more volatile. Liquidity goes into the real economy looking for higher returns.

It is not a coincidence the market peaked in August-November (depending on which index you use) when the economy took off. What are the implications for you as an investor? Let's look first at the data.

Most analysts have been busy in lowering their forecasts as soon as the Asian problems became apparent. We told you we were going to be pragmatic and look at the facts. And the facts are saying the economy is and will be strong.

Consumer confidence remains high and this bodes well for sales. It is no surprise retail sales are strong. Production is growing rapidly as manufacturers build inventories to catch up with sales. Car sales are also very strong.

Employment is expanding at a healthy clip, suggesting the labor market remains tight. The decline in mortgage rates has sent new mortgage applications soaring due to refinancing and it will have a solid impact on residential construction ahead.

The money supply continues to accelerate and the dollar has strengthened in the past few months, suggesting the economy will be quite strong in the coming months.

Outlook. The data continue to point to a robust economy led by a confident consumer. As long as consumer confidence remains at current lofty levels and the money supply is accelerating, the odds favor a strong economy in the months ahead.

Investment implications. Because of the strong growth in the business cycle, the markets will remain volatile as they have been since last August. This means risk is increasing.

George Dagnino, Ph.D., Editor & Publisher. Since 1977.
65 Lakefront Drive, Akron, OH 44319-3698.
E-mail address: ac4l6@acorn.net

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