What the Smart Money Thinks

Despite signs of trouble, forecasters don't seem worried about the health of the economy.
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Every January, a group of the smartest money minds in my hometown of Chicago gets together for a luncheon sponsored by Free Market, an economic consulting firm that provides data analysis and insights for institutional money managers. The 18 guests are asked to make predictions of the high, low and closing numbers for the

Dow

,

Nasdaq Composite

, fed funds rate and 10-year Treasury note.

The competition for the forecasting prize, the Eagle statuette, is fierce. Individual scores for last year's predictions for each of the categories are ranked to the decimal point and adjusted by mean error and standard deviation. Category winners get a tacky, home-made certificate, which I've actually seen displayed in some money managers' offices! In the nearly 20 years of this contest, there have been a lot of ups and downs.

The real bragging rights go to the overall winner, who this year is well-known forecaster Jim Bianco of Arbor Research. I'll share his specific forecasts for the coming year, but perhaps of equal interest is the round-table discussion during which each participant gets a chance to share his or her reasoning for the numbers being submitted to the contest.

What Worries Money Managers

The commentary at the luncheon is as interesting as the numbers. For instance, Free Market Founder Michael T. Lewis raised the issue of how we measure inflation, calling the term "core" inflation, a "tragedy of economics." Core inflation excludes food and energy, and Lewis points out that we need to look at the big picture. It's a mistake to leave out the impact of energy prices, which certainly will move through the economy, he says.

Economist David Hale is a friend of incoming

Fed

Chairman Ben Bernanke, who certainly isn't making any public predictions. But Hale figures that a slowdown in housing inflation during 2006 will give the Fed some room to drop rates later in 2007. Hale figures higher rates between now and then will slow housing borrowing.

Still, Hale's no housing bear, pointing out that since the depression the U.S. has never had a

national

decline in housing prices, in spite of drops in individual markets like California in the early 1990s.

I also found it interesting how frequently the participants referred to Iran -- not Iraq -- in terms of its potential impact on the economic outlook. Some factored in a confrontation over Iran's nuclear energy plans. But money manager Sy Lotsoff figures that Congress might give the president authority to take action, which could scare Iran's rulers into negotiation.

Everyone had an opinion on oil prices, noting that the previous year Bianco's forecast of an oil price over $55 a barrel had been startling. Now, several were factoring into their forecasts the impact of oil approaching -- or exceeding -- $100 a barrel in 2006.

Perhaps most astonishing, no one in the group was forecasting a recession. Some thought gross domestic product might slip to around 2% by the end of the year, while others stuck with forecasts around 3.5% (compared with an average of 4.1% growth over the last two years).

Crystal Ball Gazing

If someone had a crystal ball a few years ago and had forecast that the Fed would raise short-term interest rates 13 times, oil would be near $70 a barrel, and the federal budget deficit would exceed $400 billion, you'd definitely have figured the economy would be staggering into recession by now.

Instead we have interest rates on 10-year bonds at only 4.37% -- actually flat or

below

some shorter-term rates -- and an economy that is still growing. Alan Greenspan called it a "conundrum" last February, and it remains so today, though there are many explanations.

Bianco says that 2006 is likely to be a continuation of 2005, though with slightly slowing growth. He figures short-term rates will remain higher than long rates all year, cutting into the profitability of the financial services sector. Still, he prognosticates that the Dow could rise as high as 11,500, and that the Nasdaq will end the year around 2300. And he figures we'll live with oil around $70 a barrel -- a price driven by demand, and necessary to encourage more exploration and production.

His outlook for consumers' personal finances is a bright one. Bianco says too many people are forecasting the end of the housing market, which he figures will stay strong in most parts of the country this year. After all, he notes, most people with adjustable-rate mortgages won't face a reset for another two years. And if inflation picks up a bit, it won't bother consumers who see it as beneficial for home prices.

Of course, all those forecasts could go out the window in the event of an unexpected terrorist or health threat. But we've weathered some of those in the past -- as well as all those interest rates hikes -- and our economy remains strong. The "smart money" doesn't seem worried. Maybe that's the best indicator of all. And that's The Savage Truth.